Journal of Economic Literature 2009, 47:3, 730–771 http:www.aeaweb.org/articles.php?doi=10.1257/jel.47.3.730

Toward a Theory of Regulation for Developing Countries: Following Jean-Jacques Laffont’s Lead Antonio Estache and Liam Wren-Lewis* The efficient operation and expansion of infrastructures in developing countries is crucial for growth and poverty reduction. However, recent reforms aimed at improving the performance of these sectors have had limited success. Evidence suggests that, in many instances, this was because the traditional regulatory theory relied on by policymakers was not suitable for the institutional context in developing countries. This article surveys more recent theoretical work focusing on problems with regulation in these countries. At the heart of the survey is the work of Jean-Jacques Laffont, who, in the last decade of his life, set about developing a theoretical framework for regulation in developing countries. We consider the implications of his work, which focused on the key institutional limitations faced in developing countries. We then discuss where experience suggests that there are important omissions from this modeling, bringing in extensions and alternative approaches pursued by other authors. We conclude by summarizing the key ways in which regulatory policy will be different when institutions are weak. Overall, we find that an understanding of the institutional context and its implications are crucial when designing a regulatory framework for developing countries.

W

1.  Introduction

Laffont (2005, p. 245)

ith this insight, Jean-Jacques Laffont concludes his argument that utility regulation in developing countries faces problems fundamentally different from those in advanced economies. The accumulation of information on the unsatisfactory results of reforms in the least developed countries increasingly vindicates Laffont’s viewpoint. Policymakers and advisors are

* Estache: ECARES, Université Libre de Bruxelles. Wren-Lewis: Oxford University. The authors have benefited from ­d iscussions, comments, and suggestions from Emmanuelle Auriol, Daniel Benitez, Francois Bourguignon, Claude Crampes, Mathias Dewatripont, Clotilde Giner, Tony Gomez-Ibanez, Roger Gordon, Charles Kenny, Atushi Iimi, Jose-Luis Guasch, Paul Noumba-Um, Martin­

Rodriguez-Pardina, Martin Rossi, Richard Schlirf, Tina Soreide, Stephane Straub, John Vickers, Simon WrenLewis, Xinzhu Zhang, and seminar participants in Bergen, Brussels, Paris, Stockholm, and Washington, D.C., as well as three anonymous referees. Any mistake or misinterpretation of facts is our responsibility.

Developing economies are often described as “economies with missing markets.” In the contractual world of regulation, missing markets translate into incomplete contracts. Contracts are incomplete because of players’ bounded rationality, as in any economy—but also because of institutional weaknesses.

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Estache and Wren-Lewis: Toward a Theory of Regulation for Developing Countries 731 indeed finding that the framework of traditional regulatory theory, elaborated and applied in the developed world, is of much more limited use in developing countries than anticipated ten to fifteen years earlier. The need for a regulatory theory specific to LDCs is exemplified by the recent case of the privatization of the water and electricity company of Mali. Following the recommendations of international advisors, the project started in 2000 using a model of regulation successful in developed countries. Prices were to be set at a level that allowed costs to be recovered, which theoretically would increase efficiency and allow the firm to meet its investment responsibilities. This contract was then overseen by an independent regulator in order to prevent too much political interference. However, the project did not proceed as planned. The population’s limited ability to pay made large price increases politically intolerable, forcing the government to pay subsidies to the firm. Belatedly, the firm became aware of the financial and political risks involved in such a poor country and this made meeting its investment objectives practically impossible. Finally, the combination of gaps in the contract, public subsidies, and the framework’s unsuitability meant that there was constant negotiation involving politicians, undermining the regulator’s independence. A major renegotiation was attempted in 2005, but there

was no consensus among experts as to how the framework should be adapted to the country’s context. The conflict ended soon after with the foreign operator leaving the country. The risks associated with a failure to adapt infrastructure regulation to developing countries are not minor given the context of insufficient infrastructure provision. In 2000, approximately 20 percent of the population of low income countries lacked access to improved water sources, 40 percent to networked electricity and to sanitation, and 70 percent to telephone services.1 Except for phone services (since here technology has more than compensated for policy failures), the growth rates in access in many countries are only slightly higher than the population growth rates. Widening access and improving services have become a top priority as evidence on the importance of infrastructure for poverty reduction and growth continues to mount.2 In an attempt to increase investment and improve efficiency in infrastructure, international agencies generally advised countries to open their infrastructure industries to the private sector. However, for many countries, particularly those with the lowest income, private-sector participation has been disappointing. Frequently, private ownership and management have not improved performance, notably in sectors where there is no competition.3 These ­failures, accompanied

1 Furthermore, those with access tend to be wealthy. Of the poorest quintile in low-income countries, only about 40 percent had access to improved water sources, 25 percent to sanitation, 10 percent to electricity, and 5 percent to a telephone. These statistics are from Antonio Estache (2008). 2 See Estache (2008) for a survey. Studies showing the importance of infrastructure include Hadi Salehi Esfahani and Maria Teresa Ramírez (2003), Cesar Calderon and Luis Servén (2004), Federica Maiorano and Jon Stern (2007), and Stephane Straub (2008) on growth; Estache, Vivien Foster, and Quentin Wodon (2002), Calderon and

Servén (2004), Marianne Fay et al. (2005), and United Nations Development Programme (2006) on poverty. 3 See David Parker and Colin Kirkpatrick (2005), William L. Megginson and Natalie L. Sutter (2006), and Narjess Boubakri, Jean-Claude Cosset, and Omrane Guedhami (2008) for surveys of the empirical literature on privatization in LDCs. The latter survey in particular argues that the institutional environment plays a greater role in determining performance than in developed countries. See Kate Bayliss (2002) and Nancy Birdsall and John Nellis (2003) for surveys of the distributional impact of privatization.

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by increases in prices, have led to widespread dissatisfaction with privatization.4 What went wrong? It appears that both regulatory policy and the institutional framework are each greater determinants of performance than the form of ownership or management used in the sector.5 This view was recently reemphasized by François Bourguignon (2005) who states that “Today, it is increasingly recognized that, in many instances, the problem was that reformers disregarded the functioning of regulatory institutions, assuming implicitly they would work as in developed countries” (pp. xi–x). In sum, the facts and the casual observations are all consistent with Laffont’s argument that weaknesses in institutions complicate regulation in LDCs.6 This mirrors the growing emphasis placed on institutions in development economics, as in economics more generally.7 This article aims to discuss explicitly the limitations of traditional regulatory theory by considering the critical problems in developing countries that are not typically included in models of regulation. The survey draws insights from more recent theoretical work that has concentrated on examining these problems and finding solutions that are tailored to LDCs. At the heart of our survey is the work of Laffont. Before his untimely death in 2004, he set about creating a new theoretical framework for regulation in developing countries that aimed to address

the risk of mismatch between imported regulation and local regulatory needs. The essay is divided into three parts. In section 2, we set out a basic model of monopoly regulation similar to that used by Laffont and consider the baseline case of a developed country with complete institutions. We then explore how the model can be adapted to consider four key institutional limitations common in developing countries: limited regulatory capacity, limited accountability, limited commitment, and limited fiscal efficiency. We thereby introduce numerous results obtained by Laffont regarding both the problems caused by the institutional weaknesses and potential solutions. Where appropriate, we then relate these insights to examples and results in the empirical literature. Section 3 then considers where experience suggests that there are important omissions from this modeling. We discuss how work by other authors may be used to fill some of these gaps, bringing in further literature focused on incentive theory as well as insights from other theoretical approaches. Finally, we outline what we consider to be the priorities for future research in this area in section 4. From the overall analysis, we conclude that institutional weaknesses in developing countries will make the optimal regulatory policy different from that of developed countries. We summarize some of the

4 David Hall, Emanuele Lobina, and Robin de la Motte (2005), Mary M. Shirley (2005), Estache (2006), and Daniele Checchi, Massimo Florio, and Jorge Eduardo Carrera (2009) each document this increasing dissatisfaction and provide possible explanations, including equity effects and the negative effects on particular interest groups. 5 For example, Estache and Martin A. Rossi (2005) and Yin-Fang Zhang, Parker, and Kirkpatrick (2008) find evidence of the importance of regulatory policy and governance over ownership in the electricity sector using country-level and firm-level data respectively. Paul Cook and Yuichiro Uchida (2003) and Hossein Jalilian, Kirkpatrick, and Parker (2007) find regulation (and not

privatization) has a significant positive effect on growth, while Omar Chisari, Estache, and Carlos Romero (1999) show with a CGE model that, while the rich have benefited from privatization in Argentina, the poor only gain through regulation. Oliver E. Williamson (2000) argues that the failure of mass privatization in Russia surprised many economists precisely because institutions had not been included in the analysis. 6 We will use the expressions “developing countries” and “less developed countries” (LDCs) interchangeably. 7 See Williamson (2000), Daron Acemoglu, Simon Johnson, and James A. Robinson (2005), Avinash K. Dixit (2004), and Dani Rodrik, Arvind Subramanian, and Francesco Trebbi (2004).

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Estache and Wren-Lewis: Toward a Theory of Regulation for Developing Countries 733 ways in which regulatory policy should be designed ­differently in LDCs, including the ­implications for the type of regulatory regime and structure of agencies. Since different types of institutional weakness push for different solutions, we argue that there will not be a complete policy set of “best practice” in LDCs. An understanding of the institutional context and its implications are, thus, crucial when designing a regulatory framework for developing countries. 2.  Laffont’s Focus on Institutional Weakness The theory of economic regulation has advanced significantly over the last quarter century.8 Laffont has played a key part in that advance, using the tools of mechanism design to emphasize the importance of incentives and asymmetric information.9 However, in the last ten to fifteen years of his life, Laffont became increasingly concerned that this impressive progress in the theory of regulation had ignored the specific characteristics of LDCs. This, he argued, was particularly critical since the difficulty of implementing reforms in developing economies was being grossly underestimated. Laffont worried that advisers in developing countries did not have an appropriate intellectual framework to draw upon. As a result, not enough importance was being given to regulation and reforms might not yield the expected results. 8 For reviews of the economic theory of infrastructure regulation see, for example, Laffont and Jean Tirole (1993), Mark Armstrong, Simon Cowan, and John Vickers (1994), David M. Newbery (1999), Ingo Vogelsang (2002), and Armstrong and David E. M. Sappington (2007). 9 This was recognized by the Nobel Prize Committee (2007), which credited Laffont’s work on regulation as a key application of mechanism design. See Eric Maskin (2004) and Tirole (2008) for overviews of Laffont’s work. Michael A. Crew and Paul R. Kleindorfer (2002) and Vogelsang (2002), for example, provide critiques of such an approach.

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Laffont’s last book, Regulation and Development, summarizes some aspects of what can go wrong with regulation if the characteristics of developing countries are not taken into account properly. On the one hand, these lessons are humbling—Laffont exposes the difficulty of applying most theoretical models to the developing country context. On the other hand, the book instills optimism—it shows the tools of incentive theory have the potential to increase our understanding of many of these problems and indicate potential solutions. Within the book and in his other works on the subject, Laffont has focused on problems stemming from institutional failures. For the purposes of this survey, we use a broad definition of institutions, which we take to be the “rules of the game” that structure players’ behavior as well as the organizations that implement these rules.10 Clearly one way to deal with institutional limitations is to change the institutions themselves. However we do not consider broad institutional change here since this generally comes about slowly and due to factors outside of regulation.11 We argue that the key aspects of institutional failure affecting regulation in LDCs can be grouped into four broad limitations: limited regulatory capacity, limited commitment, limited accountability, and limited fiscal efficiency. While many developed countries also suffer from some of these 10 This is thus slightly broader than the definition of Douglass C. North (1990), since he separates institutions from organizations, and is closer to that of Avner Greif (2000) who defines them as “a system of social factors— such as rules, beliefs, norms and organizations—that guide, enable and constrain the actions of individuals” (p. 257). For other definitions of institutions, see Williamson (2000) and Acemoglu, Johnson, and Robinson (2005). 11 See Acemoglu and Robinson (2008) for an explanation as to why institutions are persistent and North (1990), Williamson (2000), and Greif and David O. Laitin (2004) for theories of how they change. Following the idea of relative price changes, R. Maria Saleth and Ariel Dinar (2004) suggest that water scarcity may prompt institutional reform.

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limitations, there they are generally of second-order importance both in theory and in practice. In developing countries, on the other hand, the size and nature of these four limitations often dominates regulatory outcomes. Furthermore, since the relative importance of each of these areas varies across LDCs, there should not be a uniform approach to regulatory policy. Limited regulatory capacity. From his frequent interactions with regulators throughout the developing world, Laffont was concerned by the need to have a theory that explicitly recognized their limited capacity—notably their limited ability to implement policy. Regulators are generally short of resources, usually because of a shortage of government revenue and sometimes because funding is deliberately withheld by the government as a means of undermining the agency. The lack of resources prevents regulators from employing suitably skilled staff, a task that is made even harder by the scarcity of highly educated professionals and the widespread requirement to use civil service pay scales.12 Beyond the regulator itself, an underdeveloped auditing system and inexperienced judiciary place further limits on implementation. Limited accountability. The second recurring institutional failure discussed in Laffont’s work is the fact that institutions in developing countries are often less accountable than those in the developed world. Institutions that are designed to serve on behalf of the government or the people, including regulatory agencies, may in fact not be answerable to their principals and, hence, are free to 12

See Preetum Domah, Michael G. Pollitt, and Stern (2002) for evidence of capacity constraints. The African Forum for Utility Regulation (2002) and Kirkpatrick, Parker, and Zhang (2005) both undertake surveys of regulatory agencies in LDCs. The findings of the former concluded that a third of surveyed agencies are bound to paying government set salaries and two thirds of surveyed agencies require government approval of their budget.

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carry out their own objectives. While Laffont does not report any systematic statistics, his casual observations have been documented by other authors.13 Where accountability is lax, collusion between the government and various interest groups, including regulated firms, is more likely to occur. Indeed, there is abundant evidence of corruption in both the privatization process and in regulation in LDCs.14 The risk of collusion underpins Laffont’s dissatisfaction with modeling regulators and governments as benevolent welfare maximizers. Limited commitment. Laffont’s work also reveals that he was convinced that the institutional framework in many developing countries makes it impossible to rely on contracts. The difficulty is demonstrated best by the prevalence of contract renegotiation that Laffont analyzed empirically in the last couple of years of his life.15 With Guasch and Straub, he investigated why, in Latin America between 1985 and 2000, more than 40 percent of concessions (excluding the telecoms sector) were renegotiated, a majority at the request of governments. Fear of future renegotiation is a serious impediment to attracting private sector participation. Moreover, the inability to rely on contracts is particularly damaging given the greater uncertainties about cost, demand, and macroeconomic stability that exist in LDCs. Limited fiscal efficiency. The final source of institutional failure explicitly addressed by Laffont is the weakness of fiscal institutions. There is a clear concern that public institutions are unable to collect adequate revenue

13 For instance, Stern and Stuart Holder (1999) show, in a survey of Asian regulators, that very few are transparent or accountable. 14 For example, see Kjetil Bjorvatn and Tina Søreide (2005) and Sudeshna Ghosh Banerjee, Jennifer M. Oetzel, and Rupa Ranganathan (2006) for evidence of corruption in private sector involvement. 15 J. Luis Guasch, Laffont, and Straub (2006, 2007, 2008).

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Estache and Wren-Lewis: Toward a Theory of Regulation for Developing Countries 735 to allow direct subsidies when the ability of consumers to pay for services is limited. In infrastructure, this limitation is apparent in the slow progress that state-owned enterprises have made in increasing access to networks.16 When both fiscal surpluses and the ability to pay of the majority of users are limited (as is often the case in sub-Saharan Africa, for instance), the speed at which investment can be financed is much slower than when governments can finance any resource gap.17 Unfortunately, governments and regulators are in a catch-22 situation. The scale of network expansion required to widen access to services, and the inability of many citizens to pay tariffs at a level that will ensure cost recovery, mean that private or public enterprises are unlikely to be financially autonomous.18 However, the limited fiscal efficiency of the poorest countries is such that governments will not be able to finance high levels of subsidies. When studying the implications of these institutional limitations, Laffont’s strategy is twofold. In the first approach, existing models are considered with reference to ranges of parameter values that are likely in LDCs. In these cases, it is the scale of the problem that is different from rich countries and the implications for policy may be discernable using a framework applicable to both. In the second approach, models are extended to allow for the relaxation of traditional assumptions that are no longer appropriate. This is ­necessary 16 George R. G. Clarke and Scott J. Wallsten (2003) give evidence of the limited success of state-subsidized network expansion and suggest that mistargetting is a major problem. 17 In terms of consumers’ ability to pay, Kristin Komives et al. (2005) find about 20 percent of Latin American households and 70 percent of households in Africa or Asia would have to pay more than 5 percent of their income for water or electricity services if tariffs were set at cost recovery levels. 18 Javier Campos et al. (2003) find that the fiscal benefits of privatization decrease over time and argue that it is because the need for public investment is only gradually recognized.

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for situations where the nature of the ­problem is qualitatively different and, hence, the standard structure is not useful. In the rest of this section, we summarize the key insights that come from Laffont’s analysis of each of these institutional limitations. To do so, it is helpful to build a basic model of monopoly regulation very similar to that used in Laffont (2005) and provide a complete institutions benchmark to compare results to. We then use this model to illustrate the methods and implications of Laffont’s work when considering each of the four institutional limitations. For each limitation, we consider the problems that arise as a result and a number of solutions that theory suggests. 2.1 A Basic Model of Monopoly Regulation The model centers on a monopolist ­producing a quantity q of a good for domestic consumption. Its cost function is C(q) = (β − e) q − F, where β is a firm­specific characteristic representing its underlying cost, e is an effort level that decreases the marginal cost, and F is a fixed cost.19 β represents costs that are outside of the firm’s control, such as factor prices or ­technology. We use a binary model whereby the firm is either low-cost, β = ​β​ __ __  (occurring with probability v) or high-cost, β = β  ​ ​  (occurring with probability 1 − v). e is the part of the marginal cost that is controllable by the firm directly. For example, the manager may be able to reduce costs by purchasing from the cheapest supplier or by reducing mistakes. Exerting an effort level of e causes the firm a disutility of ψ(e) (ψ ′ > 0, ψ″ > 0, ψ‴ > 0). The monopoly’s revenue from sales is qp, where p is the price level. In addition to this revenue, the monopoly receives a transfer 19 See Laffont and Tirole (1993), Armstrong, Cowan, and Vickers (1994), and Armstrong and Sappington (2007) for detailed expositions of models in this style.

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t from the government.20 The monopoly’s ­welfare is then U = qp − (β − e) q − F − ψ(e) + t. We will also describe U as the “rent” the firm receives from being the monopoly supplier. The monopoly has a participation constraint such that, after β is revealed, its welfare must be no less than 0, i.e., (1)  ​U​ __ ≥ 0 and

__

(2) ​U ​ ≥ 0, when β = __ β​ ​  , where __  is the firm’s utility __ __ ​U​ ​  ​. We_ similarly deand ​U ​ that when β = β  _ __ __ ​  , q, q ​ ​  , _t​ ​    , and ​t ​  as the effort fine e  , e ​ ​  , p, p ​ ­levels, price levels, quantities produced, and transfers made in these respective cases. This participation constraint assumes that the firm can leave and obtain a reservation utility of zero after it has discovered its type (i.e., its cost level). The assumption is crucial since it prohibits the government motivating the firm by giving one type a negative utility. We further assume that the government wishes the firm to participate regardless of its type. If the firm chooses to participate, it decides upon levels for price and effort, but it must abide by a contract agreed with the government. Consumers’ gross surplus from consuming q a quantity q of the good is S(q) = ​∫0​ ​  ​P(q′)  dq′, where P(q) is the inverse demand function (S′ > 0, S″ < 0). Consumers also pay taxes to fund the transfer to the monopoly. Raising an amount t in taxes costs consumers (1 + λ)t, where λ > 0 is the opportunity cost of public funds. Hence, consumers’ net surplus is V = S(q) − qp − (1 + λ)t. Consumers are 20 See Laffont and Tirole (1993, pp. 145–55) for details of how the model changes when transfers are removed. Generally, when prices must be used to generate the ­revenue here provided by transfers there will be a loss of efficiency. This may, however, be mitigated if the firm can use two-part tariffs rather than linear prices.

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­ elfare maximizing and, therefore, in equiw librium we have p = P(q) = S′(q), i.e., demand is determined such that price is equal to the marginal benefit. The benevolent government aims to maximize the following social welfare function: (3)  W = U + V

= S(q) − (β − e) q− ψ (e) − F − λt.

We assume here that F is common knowledge. We also assume that the government can observe price and marginal cost c = β − e but they do not observe the components of this cost—i.e., they do not observe β and e. The contract between the government and the firm can therefore specify the price the firm should sell at, the marginal cost level it should obtain, and the transfer from the government to the firm. The asymmetry of information between the government and the firm is at the heart of Laffont’s model of regulation. The government does not know directly what proportion of the firm’s costs are controllable in the short term (e) and what proportion is uncontrollable (β). Here e is, therefore, a moral hazard variable—the inability of the government to observe the effort level means that it cannot directly ensure that the firm is doing all it should to reduce costs. On the other hand, the nonobservation of β introduces an element of adverse selection. Even though β is not controllable by the firm, the government would like to know this information to make sure that the firm isn’t pricing higher than it should. A regulator is employed to reduce the asymmetry of information by learning the value of β. The regulator is endowed with an information technology that obtains a private signal r that may give information about the firm’s cost. With probability ξ, the firm’s cost is revealed to the regulator (r = β) and with probability 1 − ξ they receive no information

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Estache and Wren-Lewis: Toward a Theory of Regulation for Developing Countries 737 (r = ∅). We assume that the signal the regulator receives is “hard” information. This means that the regulator cannot report that the firm is of a particular type unless it has received a signal revealing this to be true. However, it can hide information and report that the signal is ∅ even if this was not the case. In other words, the signal can be hidden but it cannot be faked. To make use of the regulator’s information r, the government asks it to report the signal. We assume that the government can write an enforceable contract with the regulator that specifies transfers to be paid to the regulator as a function of its report. These transfers are paid from government revenue, so paying the regulator a transfer s costs consumers (1 + λ)s. If the regulator’s welfare is included in the social welfare function, the excess burden to society of this transfer is therefore λs. We also assume that the firm observes both the regulator’s signal and their report to the government. The firm can contract on the regulator’s report and make dependent transfers. Transfers between the regulator and the firm are costly because they are illegal, i.e., there may be costs undertaken to hide the transfer or a penalty if the parties are caught. Hence, for any bribe given by the firm, the regulator only enjoys a fraction k of the bribe, where k ∈ (0, 1). k here represents the ease with which bribes can be made, i.e., a higher value of k means that there are fewer costs involved. Finally, we assume that the government decides upon the set of contracts offered to the firm before the regulator makes its report. The set of contracts offered will be conditional on the regulator’s report and this allows the government to influence through the contract specification the firm’s decision of whether to bribe or not. 2.2 Complete Institutions Benchmark Let us briefly detail the core results of the model in a situation where the country does

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not suffer any of the four institutional limitations outlined above. When the regulator reports the value of β, there is no asymmetric information. Hence, for this case, the government can simply maximize the welfare function (3) subject to the participation constraints (1) and (2) binding. The result is that the markup of price above marginal cost is the same for both types of firm. Letting η be the elasticity of demand, prices are given by the following equation: p − (β − e) _____ 1  ​  .   = ​  λ   ​  ​ __ (4) ​ _________ p ​  1+ λ η The government sets the price at a level above marginal cost where the distortion caused is of the same magnitude as the distortion caused by taxation. The transfer t is then set at such a level such that there will be no excess rent given to the firm, i.e.,__it will have its minimum utility of zero (​_U​ _ = ​U ​ = 0). Furthermore, the effort level exerted by the firm will be efficient for both types, i.e., ψ′(e) = q. When the regulator reports a signal of r = ∅, the government is unaware of the value of β. From the revelation principle, there is no loss of generality in restricting the analysis to_ direct revelation mecha_ __ nisms {(​_t​  , c , p), (​t ​ , ​c ​ , ​p ​ )} that specify for each ­message from the firm the transfer, marginal cost, and price that will occur.21 In order for the firm to be willing to accept the contract designed for their type, such a mechanism must satisfy the participation constraints (1) and (2) as well as the incentive compatibility constraints (5)

__

_

​  + Φ(​e ​ ) ​U​ __ ≥ U ​

21 The revelation principle states that mechanisms involving the agent revealing their type truthfully can achieve the same results as any other mechanism that satisfies the agent’s incentive compatibility constraints. See Laffont and Tirole (1993, p. 120) for a proof in this context.

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738 and

__

_

(6) ​U ​ ≥ U​ _​ _ − Φ (​e ​ + Δβ). __

Here Δβ = ​β  ​ − ​β​ __  and Φ(e) = ψ(e) − ψ(e − Δβ), which is the difference in cost between the high-type and the low-type exerting a given effort level. These incentive compatibility constraints make sure that neither type of firm wishes to pretend to be the other type—i.e., they will reveal their type truthfully. A standard result is that, when there is an asymmetry of information (r = ∅), the binding constraints will be the participation constraint of the high-cost firm (2) and the incentive compatibility constraint of the low-cost firm (5).22 Solving the government’s optimization problem for this case results in prices again set as in equation (4). However, while the high-cost firm will again receive no rent, the low-cost firm will receive a _ rent ​_U​ _ = Φ(​e ​ ). We label this the firm’s “information rent” since it is received as a result of the firm holding more information than the government. Since this rent effectively comes _ out of public funds, it costs society λΦ(​e ​ ). The low-cost firm receives an informa_ tion rent of _U​ ​ _  = Φ(​e ​ ) when the regulator reports a signal of r = ∅ and no rent when it reports the signal r = ​β​ __ . Hence, the lowcost firm will want the regulator to hide its signal if it receives one. Indeed it will be willing to bribe the regulator an amount of _  , up to Φ(​e ​ ) to report r = ∅ if, in fact, r = ​β​ ___ of which the regulator would receive kΦ(​e ​ ). If the government wishes to prevent collusion from occurring, it can do so by paying an _ incentive payment of s = kΦ(​e ​ ) every time the regulator reports that r = β​ ​  . Al_ __ though this costs ­society λkΦ(​e ​) , it will always be optimal for the government to ­prevent collusion in this way since otherwise

22 See

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Laffont and Tirole (1993).

the cost of the firm’s information rent is _ λΦ(​e ​ ) and__k < 1.23 If r = ​β  ​, then the firm has no incentive to keep this information hidden and will not want to bribe the regulator. The government, therefore, will not need to give any ­incentive payment to the regulator for reporting __ r = ​β  ​. The rent that the low-cost firm receives is costly to society since it comes through higher distortive taxation and, hence, the government will wish to reduce it. Furthermore, a larger potential rent for the firm increases the size of the incentive payment the government pays the regulator and, hence, this is a further reason to decrease the low cost firm’s rent. In order to reduce the rent, the government can make the high-cost firm’s production level less appealing to the lowcost firm by increasing the high-cost firm’s _ _ cost level, which reduces e ​ ​  and, hence, Φ(​e ​) . This is disadvantageous for the low-cost firm because it decreases the quantity they would be allowed to sell. In particular, solving the government’s optimization problem gives _

__

​  (7)  ψ′(​e ​ ) = q ​

ξ _ v   ​  kd Φ′(​e ​ ). c1 + _____ ​     ​  − _____ ​  λ   ​  ​ _____ 1−ξ 1+ λ 1−v

The second term on the right hand side is negative and, hence, the exerted effort is lower than the efficient level. This term is increasing in v, since the more likely the firm is to be low-cost the less likely this distortion in effort will occur and, therefore, the government can allow the distortion to be greater. Similarly, the high-cost firm exerts less effort the greater the values of λ, ξ, and k—effects that we discuss in more detail in the sections below. On the other hand, there

23 See chapter 11 of Laffont and Tirole (1993) for further details.

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Estache and Wren-Lewis: Toward a Theory of Regulation for Developing Countries 739 is no reason for the government to distort the low-cost firm’s effort level, so ψ′(e) = q. So far we have assumed that the ­government controls the firm’s effort by directly setting its cost level c = β − e, along with the price and size of the transfer. However, we can equivalently interpret the firm’s effort level as being determined by an incentive scheme that the government gives to the firm. Rather than directly setting the firm’s price, cost, and transfer, the government can set the price and offer them a cost reimbursement rule where a proportion α of the firm’s costs are reimbursed through the transfer. The firm will then choose its effort level (and hence its marginal cost) to maximize its welfare function. Doing so means they exert an effort level according to the equation ψ′(e) = (1 − α)q. This then allows us to define the “power” of an incentive scheme. If the scheme gives the firm strong incentives to reduce costs by allowing it to reap the benefits of cost reduction, then it is described as “high-powered.” An example of such a scheme is a “price-cap” regime where the government sets a price and the transfer is independent of marginal cost. Here the firm is keen to reduce costs because they translate directly into increased profits and, hence, they will choose the efficient level of effort. On the other hand, under a “low-powered” regime the firm will have less of an incentive to reduce cost because a greater marginal cost means they will receive a higher transfer. In our model, the power of the incentive scheme is equivalent to the firm’s effort level. When there is symmetric information, both types of firm exert the efficient level of effort, and we can view this as them having been offered a high-powered incentive scheme with α = 0. When there is asymmetric information, equation (7) shows us that the high-cost firm’s effort level corresponds to an incentive scheme with α > 0. The existence of asymmetric information

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therefore decreases the power of incentives in expectation. 2.3 Limited Regulatory Capacity 2.3.1 Problems The lack of developed accounting and auditing systems in LDCs and the inability of the regulator to penalize the firm for noncompliance means that the regulator is less able to extract information from the firm. Furthermore, if regulatory agencies are staffed by inexperienced nonspecialists, then the knowledge gap between the regulator and the firm is likely to be more difficult to close without the firm’s help. In the above model, these factors correspond to a lower value of ξ, the probability of the regulator observing the firm’s type. A lower value of ξ means that there is a higher probability that the government will have to incentivize the firm to reveal its information through offering the low-cost firm a positive rent. In expectation, therefore, the firm will earn a greater rent. This is consistent with cross-country evidence from LDCs suggesting that insufficient regulatory capacity leads to excessive returns for regulated firms beyond those that could be expected from the high risks often associated with doing business there.24 In our model, this greater profit comes through a higher transfer from the government and, since this is funded through distortive taxation, this leads to lower social welfare. In a more extreme situation, common in the poorest countries, auditing systems may be so underdeveloped that auditing of cost is too unreliable to be used. In this case, we depart from the model’s assumption above that c = β − e is observable. In this case, the 24 See Sophie Sirtaine et al. (2005) and Luis Andres, Guasch, and Straub (2007).

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contract offered to the firm will just specify a quantity/price and a transfer. Since the government cannot fix the high-cost firm’s effort level, they cannot use this as a tool to decrease the low-cost firm’s information rent. Instead, the government will increase the price mark-up of the high-cost firm. This is a less efficient tool and, hence, the loss of a policy instrument decreases welfare. 2.3.2 Solutions One way the model suggests that the government may mitigate problems resulting from the limited capacity of the regulator is to alter the power of incentives. From equation (7), which specifies the high-cost firm’s effort level, we can see that less monitoring of costs (smaller ξ) implies that the government should make the high-cost firm exert more effort. In other words, the cost reimbursement scheme the government sets should include more powerful incentives. This is because the regulator discovers the firm’s cost less frequently and, hence, the government has to pay collusion-preventing incentive payments to the regulator less often. The cost of paying the regulator’s incentive payments was one of the motivations for decreasing the firm’s potential rent. As these payments are now less of a concern in expectation, there is less reason to distort the high-cost firm’s effort. Moreover, in the extreme case where costs are not observed, high-powered incentives are the only option. Here the government cannot offer a costreimbursement rule since it does not observe costs and, hence, the firm will exert the efficient effort level.25 Moving away from the situation of monopoly regulation, Laffont also suggests that competition may mitigate capacity 25 See Laffont and Tirole (1993, pp. 516–30) for a broader analysis involving the monitoring of effort and cost padding.

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problems. Competition may help to provide the regulator with more information or may serve as an alternative pressure on the firm to keep prices low.26 If competition is to be introduced, care still needs to be taken over the implications of limited regulatory capacity, for the regulator will still have several important tasks. For instance, the regulator may be involved in reducing market power and ­setting access prices. Experience in developing countries suggests that the regulation of partially competitive sectors may be as demanding on regulators as monopoly regulation.27 Chapter 5 of Laffont (2005) considers the implications that limited capacity has on access prices, which are the prices set for access to the network (or similar intermediate good). He suggests that, when there are multiple usages of a network, regulation of access should be based on broad categories of usage. For example, the price of electricity transmission should theoretically vary according to which point of the network it enters and exits, but enforcing such prices would involve detailed inspection and complex calculation. Similarly, access prices should theoretically be used to subsidize firms that have relatively little market power, but Laffont recommends against this in LDCs since the complexity of doing so gives the regulator too much discretion. These recommendations against some of those derived for access prices in developed countries also result from the significant differences in information availability between developed and developing countries.28

26 Laffont and Tchetche N’Guessan (1999), for example, model competition as an increase in ξ. 27 This point is emphasized in Ioannis N. Kessides (2005). Domah, Pollitt, and Stern (2002) study electricity regulators in LDCs and find that competition does not appear to make regulation any less complex. 28 See Armstrong, Chris Doyle, and Vickers (1996), Laffont and Tirole (2000), and Vogelsang (2003) for developed country focused analyses of access prices.

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Estache and Wren-Lewis: Toward a Theory of Regulation for Developing Countries 741 A further consideration Laffont discusses is how limited regulatory capacity impacts the design of regulatory structures.29 Generally, a lack of skilled human resources in ­developing countries is likely to push toward the creation of fewer regulatory agencies. By pooling resources, a regulator is more likely to be able to afford the professionals required to process the information it receives and experts will be able to share their knowledge more easily. In practice, this is reflected in the tendency for advisors to recommend multisectoral agencies in LDCs. This allows, for instance, legal experts to be shared by departments since many of the legal issues are the same across sectors. There is also a preference for national rather than decentralized regulation in technically demanding sectors such as telecommunications and electricity. In politically demanding sectors such as water and transport, the regulatory responsibilities are often distributed across government levels, with local monitoring of performance and national monitoring of prices and environmental spillovers. Going a step further, practitioners have suggested that developing countries would benefit from a greater use of international and regional bodies to provide support and coordination for national agencies.30 Again, the sharing of resources and experiences may help to mitigate the limited regulatory capacity faced in LDCs. Overall, limited regulatory capacity reduces the information available to the government. High-powered incentives and competition may, therefore, be useful as ways to reduce the reliance on this information within the regulatory framework. Furthermore, efforts should be made to boost the ability of regulators to deal with the information by pooling 29 See chapter 7 of Laffont (2005), which is based on Laffont and Cecile Aubert (2001). 30 This point is argued by Roger G. Noll (2000), for example.

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resources both within and across countries and sectors. 2.4 Limited Accountability 2.4.1 Problems Within the model above, we can represent the fact that accountability is more limited in developing countries as a higher value of k, the ease of making bribes. Illegal transfers between the firm and the regulator will be less costly in a situation where the regulator is less accountable.31 For example, the sanctions may be less or it may be easier to keep the transfer hidden from the government. In the model above, collusion is always prevented and the government pays the regulator a _ _ transfer of s = kΦ(​e ​ ), costing society λkΦ(​e ​ ). Hence, we can see that lower accountability (greater k) will increase the size of this transfer and decrease social welfare. However, the increase in transfers to the regulator predicted by the model appears inconsistent with experience. If anything, regulators in developing countries have fewer financial incentives to produce information than in developed countries, contrary to the model. Indeed, the more striking difference one notes in LDCs is that collusion occurs much more frequently, which does not occur in the traditional modeling above. One interpretation is that developing country governments are not behaving benevolently, but by extending the model we can also provide a normative explanation. Let us assume that with probability ζ the regulator is “dishonest” and will take bribes from the firm in the way described above. On the other hand, with probability 1 − ζ the regulator is “­honest” 31 In other situations, different interest groups will also have an incentive to capture the regulator. For example, Laffont and Tirole (1993) consider the case of environmentalists who desire lower output, while Estache, Laffont, and Xinzhu Zhang (2006) consider taxpayers who desire less network expansion.

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and will not take bribes from the firm. The government is not aware of the regulator’s type.32 With the model extended in this way, it is no longer clear that the government will always wish to prevent collusion. Doing so would mean paying the regulator an incen_ tive payment of s = kΦ(​e ​ ) for reporting that the firm is low-cost. At times, this will be a waste of public funds because the regulator will be honest and would not have colluded anyway. In developed countries, where k is small, the incentive payments involved are sufficiently inexpensive that it is worth paying them regardless of this possible waste. Hence, here there will indeed be no collusion. However, in developing countries, where k is large, it will be optimal for the government not to make these payments and instead allow collusion some of the time. We would therefore expect to see more collusion taking place in LDCs than in countries with stronger institutions. This reduces welfare because the regulator will report a useful signal less often and hence there will be more asymmetric information. Models of regulatory capture, including this one, typically assume a self-interested regulator under a benevolent government. However, this jars with developing country experience, where often the greatest fear is the unaccountability of the government, rather than the regulator. If the government is unaccountable to the populace, then it may itself collude with an interest group. This could lead it to place a different relative weight on consumer surplus in its objective function. For instance, a government who colludes with the firm will then have the welfare function (8)  

W = V + γU,

32 This is an extension similar to that used in Laffont and N’Guessan (1999) and David Martimort and Straub (2009).

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where 1 + λ > γ > 1.33 Since the government now favors the firm over the consumers, they will care less about the distortion caused by taxes to pay for the firm’s rent. Hence, in place of equation (7), we will have _

__

​  (9)  ψ′(​e ​)  = q ​

− (1/(1 + λ)) (v/(1 − v))



× cλ + (ξ/(1 − ξ)) λk + 1 − γ d Φ′(​e ​ ).

_

We can see from this equation that the power of incentives is increasing in γ. This is because the government places a higher value on the firm’s rent and, hence, is not so concerned with decreasing it through offering lower powered incentives. Furthermore, if γ > 1 + λ(1 − k), then the government would rather pay the firm an information rent than prevent collusion with the regulator. Hence, the nonbenevolence of the government may mean we also get more regulatory capture. Laffont also studies the effect of a government’s nonbenevolence on the decision to privatize.34 This is commonly a contentious decision and one in which accusations of corruption are frequent in LDCs. Suppose that, under public ownership, the government can extract private benefits in a way that is costly to society, and the government’s welfare function is a linear combination of these benefits and social welfare. If the government weighs these private benefits very highly, it may be optimal for society to privatize the firm in order to prevent this corruption—the 33 If 1 + λ < γ, then the model becomes uninteresting as the government simply transfers all of consumers wealth to the firm through taxation. 34 See chapter 3 of Laffont (2005), which is based on Laffont and Mathieu Meleu (1999). In this case, nonbenevolent means that the government can take some rents for their personal use. Laffont (1999) surveys various ways in which incentive theory can be used to model aspects of political economy.

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Estache and Wren-Lewis: Toward a Theory of Regulation for Developing Countries 743 government, however, will be unwilling. Now suppose that, in addition, the government can siphon off a portion of the revenues from privatization. If this portion is significantly large, the government may be willing to privatize even when it is not in the interests of society (i.e., even if the costs of the former type of corruption are not too large). Hence, limited accountability may distort the privatization decision either way, with the distortion depending on the government’s nonbenevolence and the methods through which it can extract private benefits. 2.4.2 Solutions In terms of contract design, from equation (7) we can see that more limited accountability (higher k) calls for less powerful incentives. This is because the temptation for collusion comes through the possibility of information rents accruing to the low-cost firm. Since these rents are smaller when the power of incentives is lower, the government can decrease the stakes involved in collusion by making incentives less powerful. This may also help to undo the distortion caused by the nonbenevolence of the government showed in equation (9). Reducing the size of the potential information rent is an instance of the general principle that one can decrease the costs of corruption by lowering the incentives of interest groups to hide information. Another example can be found in the case where there is the potential for collusion between taxpayers and the regulator. Here taxpayers may wish to bribe the regulator if asymmetric information results in a higher price and, hence, less taxpayersubsidized network expansion.35 Again, the costs of corruption can be mitigated by the government lowering the incentive of taxpayers to bribe. In this case, the government does so by promising less network ­expansion. Hence, if ­governments are responding 35 This is explored in Estache, Laffont, and Zhang (2006).

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o­ ptimally to the threat of collusion, then we would expect to see less efficiency and less network expansion in corrupt countries. This is indeed consistent with empirical evidence from LDCs.36 Limited accountability in developing countries also has implications for the design of the regulatory structure. In particular, governments may find it easier to prevent regulatory capture if there are more regulators. If different agencies collect similar information, each regulator may ignore the externality it imposes on the others by revealing this information.37 To see this effect in our model, suppose that in place of there being one technology that may reveal the costs of the firm, there are two—r1 and r2 —with the stochastic structure of the signals given by

ξ11 = ℙ(r1 = r2 = β),



ξ12 = ℙ(r1 = β and r2 = ∅),



ξ21 = ℙ(r1 = ∅ and r2 = β),



ξ22 = ℙ(r1 = r2 = ∅).

The case where both technologies are operated by a single regulator is equivalent to the model above with ξ = ξ11 + ξ12 + ξ21. As we have shown, in order to prevent collusion in this case the government will be required _ to give an incentive payment of kΦ(​e ​ ) with probability vξ = v(ξ11 + ξ12 + ξ21). Now suppose that two different regulators collect these two signals. We assume that each regulator is aware of the signal the

36 See, for example, the cross-country regressions in Estache and Eugene Kouassi (2002), Estache, Ana Goicoechea, and Lourdes Trujillo (2009), and Ernesto Dal Bó and Rossi (2007). 37 This model is an adaptation of Laffont and Martimort (1999). This can be seen as an example of the general principle that competition amongst bureaucrats decreases corruption, as discussed in Susan Rose-Ackerman (1978) and James Q. Wilson (1980), amongst other places.

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other receives and they cannot collude with each other.38 In equilibrium, each regulator expects the other to report their signal truthfully. Hence, if both regulators receive informative signals, each will anticipate that the other will reveal it and they will believe any collusion would be ineffective. Therefore, the government just needs to give incentive payments to the regulatory agencies when only one reports an informative signal. In _ particular, it will pay kΦ(​e ​ ) to agency i if β​ ​   and r j = ∅. Since this only occurs r i = __ with probability v(ξ12 + ξ21), the cost of collusion has been reduced.39 As well as competition between agencies, competition within the industry may appear to be a possible avenue to reduce corruption. If competition reduces the need for regulation, then the regulator will have less power and, hence, cannot demand such large bribes. Empirical results however do not show a clear link between competition and corruption in LDCs.40 One explanation can be given by using the extension of the model with honest and dishonest regulators already outlined. Suppose one result of competition is an increase in the ease with which the regulator can obtain information, i.e., larger ξ. We have seen in section 2.3 that a higher value of ξ implies lower powered incentives. In other words, the regulator’s signal quality and low-powered incentives are complementary instruments for reducing the firm’s expected information rent. We have also seen that, if the government allows collusion between the firm and the dishonest regulator, the power of incentives will be lower (since asymmetric 38 Of course, limited accountability is also likely to make such interagency collusion more probable. See Laffont and Meleu (1997) for an analysis. 39 See chapter 8 of Laffont (2005), which is based on Laffont and Meleu (2001), for further comparative statics. Linked to this idea is the effect decentralization has on collusion, which is considered in Laffont and Jerome Pouyet (2004). 40 See Laffont and N’Guessan (1999) for this result and the following analysis.

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information occurs more frequently). Since competition and low-powered incentives are complementary, competition is therefore more valuable in the case with collusion. In other words, the greater information available through competition increases welfare whether corruption is tolerated or not, but the increase is greater when there is more corruption. Hence, an increase in competition means the government will be less tempted to reduce corruption. A final way suggested by many practition­ ers to make the regulator more accountable is by increasing direct consumer participation.41 This can help make decisions more pro-consumer, but it may be ineffective in preventing capture if the regulator colludes by hiding information (since the regulator will simply hide the information from the consumers also).42 Consumer groups may, therefore, only be useful when they have the ability to discover or reveal information hidden from the government. This relative ineffectiveness is vindicated in practice. The success of consumer participation in LDCs has been limited by the low capacity of representative groups, which has often left the process open to capture by better-organized interest groups. Furthermore, as we have discussed, consumer participation may be damaging if current consumers, but not potential ones, are represented since they are likely to discourage network expansion. In summary, limited accountability is fundamentally linked to the information flows between actors. A general solution to regulatory capture in LDCs is, therefore, to reduce the importance of information that any potentially unaccountable agent holds. This may be through decreasing the system’s dependence on such information (for instance, by lowering the power of incentives) or creating ­alternative information sources (by, for 41 See Cecilia Ugaz (2003), for example. 42 See Laffont and Tirole (1993), chapter

11.

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Estache and Wren-Lewis: Toward a Theory of Regulation for Developing Countries 745 e­ xample, creating multiple regulatory agencies or competition). Additionally, it is worth noting that, even if these measures increase total welfare, they may not decrease the frequency of corruption in developing countries.

In his analysis, Laffont distinguishes between three forms of limited commitment.43 The first form, “commitment and renegotiation” means that the contract can be renegotiated at a later date if both parties wish to do so. However, so long as one party does not wish to renegotiate, both will continue to be committed to it. The second form, which is labeled “noncommitment,” means there is the possibility that the government may break the contract in the future even if this disadvantages the firm. “Limited enforcement,” the third form, is essentially the opposite of this. Here the firm may be able to force the government against its will to renegotiate the contract. In general, commitment and renegotiation is damaging as it restricts contracts to being efficient ex post. In the model above, the possibility of mutually advantageous renegotiation decreases welfare. This is because the government may no longer (credibly) offer a contract to the firm that involves lowpowered incentives. Once the high-cost firm reveals its type by picking this contract, both parties would like to renegotiate to a contract where the firm exerts its efficient effort _ __ ​  . Foreseeing that the high-cost level ψ′(​e ​ ) = q ​ firm’s effort would in fact not be distorted, the low-cost firm will want to pretend to be

high-cost. As a result, the government will have to offer a higher information rent to the low-cost firm, reducing welfare. While the threat of commitment and renegotiation is a problem, in many developing countries the greatest concern among ­practitioners is government noncommitment. Large-scale investment, which is desperately needed in many LDCs, may not take place if governments cannot promise to allow investors to make a sufficient return. Investment in utilities is particularly vulnerable to government noncommitment because governments are always very involved in their operation and the investment is long-lived and nontransferable. To explore this problem in the model, we can add investment in the following way. Let us suppose that, rather than β being given completely exogenously, the firm can influence its value by undertaking investment I before β is revealed. This investment increases the probability that the firm will be a low cost type, i.e., v = v(I) (v′ > 0, v″ < 0).44 If the government is able to commit to reimbursing a chosen level of investment, __ then __ they will then set__v′(I) = 1/[ ​_U​ _  − ​U ​ + ​  ], where _V​ ​ _  and ​V ​ are consumers’ sur​_V​ _  − V ​  pluses defined in the standard way. Optimal investment increases as the benefits of having a low-cost firm increase. However, if the government can make no commitments to the firm at the investment stage, then the firm will only take into account its private benefits of__investing. We will then U​ − U ​ ​  ]. Hence, noncommithave v′(I) = 1/[  ​__  ment will produce underinvestment. This is consistent with cross-country evidence from LDCs documenting a negative correlation between the government’s ability to commit and investment.45

43 The first of these cases is studied in section 1.9 and chapter 10 of Laffont and Tirole (1993), and the second in chapter 9. The third case is modeled in chapter 4 of Laffont (2005), which is based on Laffont (2003), and is then extended in Guasch, Laffont, and Straub (2006).

44 This component is taken from Laffont and Tirole (1993) since investment is not modeled in Laffont (2005). 45 See, for example, the cross-country evidence of Banerjee, Oetzel, and Ranganathan (2006) that greater political stability increases private investment.

2.5 Limited Commitment 2.5.1 Problems

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Furthermore, in a repeated game setting, a lack of commitment will lead to what is called the “ratchet effect.” If the firm reveals itself to be low-cost, the regulator will use this information and become more ­demanding. Consequently, the low-cost firm has an extra incentive not to reveal its information to the government. The government could, hence, increase welfare if they could commit not to use this information. While problems of noncommitment have also received significant attention in the context of developed countries, limited enforcement has been relatively absent from the traditional regulation literature. This is because a strong rule of law normally prevents renegotiation in developed countries if the government is unwilling. For example, if a firm were to refuse to produce unless the contract was renegotiated, it would likely be fined a large amount of damages by the government. However, in developing countries, Laffont identifies limited enforcement as a serious concern. In Ghana, for example, he notes that the incumbent monopoly for fixed telephony entered the mobile business despite this being explicitly prohibited. Similarly, in Tanzania, the regulator attempted to enforce regional mobile license but the dominant operator disagreed and began to expand nationally. These cases are backed up by evidence that about a third of infrastructure renegotiations in the Latin America sample he studied were at the initiative of the firm.46 To demonstrate theoretically why limited enforcement is problematic, Laffont considers the case where the firm only has the option of rejecting the contract before β is revealed to them, instead of afterwards as previously assumed. Hence, we replace the ex post participation constraints (1) and __ (2) with the ex ante condition v​_U​ _  + (1 − v)​U ​  ≥ 0. 46 See chapter 4 of Laffont (2005) for details of these examples, and Guasch, Laffont, and Straub (2008) for details of firm-led renegotiations in Latin America.

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With the changed participation constraint, the government can now offer a contract to the firm that gives it zero rent in expectation and still meets the incentive ­compatibility constraints (5) and (6).47 Since the information asymmetry now generates no positive rent for the firm in expectation, expected social welfare is the same as in the complete information case. __ Such a contract will however require U ​  ​  < 0, and we assume that in this case the firm may attempt__to renegotiate when it is revealed that β = ​β  ​ and enforcement is limited.48 If renegotiation takes place, the government and the firm will split the ex post social welfare in a way dependent on their bargaining power and status quo payoffs. If the firm expects to definitely be able to renegotiate, then contracting ex ante brings no benefits and the firm will earn an information rent, which brings with it the problems already discussed.49 Furthermore, renegotiation processes often involve costs. For example, investment programs may be postponed, as happened in the five years that followed the Argentina 2001 crisis and the Mali case discussed earlier. Throughout the negotiations, the parties tend to receive no more than their inefficient status quo positions. Hence, limited enforcement will decrease social welfare in expectation. 2.5.2 Solutions Let us first consider the impact of limited commitment on the optimal power of incentives. In many developing countries, _ 47 For instance, we could set U​ _​ _  = (1 − v) Φ (​e ​)  and​ __ _ U ​ = −v Φ (​e ​ ).

48 This is, in practice, equivalent to considering when it is optimal for the firm to attempt renegotiation. 49 On the other hand, if there is a positive probability of the government enforcing the contract, then, in theory, the threat of renegotiation does not mean the firm __ earns any extra rent in expectation. This is because ​U ​ can be reduced further to compensate for the positive rent the firm receives should it be successful.

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Estache and Wren-Lewis: Toward a Theory of Regulation for Developing Countries 747 government-led renegotiation has been partially caused by dissatisfaction at the profits made by the firm. This would suggest that the probability of the government reneging on its commitment is a function increasing in the size of the rent promised. In this case, there will be an upper bound on the expected rent the government can commit to paying the firm. Let us label this maximum expected rent c. Then, in order for the lowcost firm not to mimic the high-cost firm, we _ require that c ≥ Φ (​e ​ ). If this constraint is not satisfied immediately, then the government _ should reduce Φ (​e ​ ) appropriately by reduc_ ing e ​ ​  . Hence, government noncommitment may favor a less powerful incentive regime because the threat of renegotiation constrains its ability to offer the firm the possibility of making large profits.50 Limited enforcement may also have implications on the power of incentives. Consider, for example, moving from the extreme case of complete enforcement to no enforcement. Here we go from the efficient contract outlined above that involves high-powered incentives to the case with asymmetric information where incentives are reduced.51 Other commitment problems may increase in severity as the power of incentives decreases. Commitment and renegotiation, for instance, forces all contracts to be efficient ex post. As Laffont (2005) points out, “no general analysis exists of how easy ­commitment is depending on the type of 50 Similarly, Richard J. Gilbert and Newbery (1994) show using a dynamic game that price-caps are less sustainable than rate-of-return schemes, while Graeme Guthrie (2006) argues that benchmarking to ­hypothetical firms requires stronger commitment since profits are more volatile. See Guthrie (2006) for a survey of the link between investment and risk. 51 In the simple model here, incentives are not intermediary in the case of a partial reinforcement because the firm’s information rent can be extracted ex ante. However, if we were to assume that there is some lower bound on the firm’s ex post welfare, then limited enforcement will lead to an information rent and it would, therefore, be optimal to reduce incentives.

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regulatory regime” (p. 23) and there is a need for further research in this area. However, the preceding analysis has shown us that perhaps the two most serious commitment problems facing developing countries may be ­mitigated by using less powerful incentives. This should, therefore, be the result borne in mind by policymakers, and indeed it is consistent with experience in developing countries. For instance, empirical results from renegotiations in Latin America suggest that price caps generally cause more renegotiations than less powerful incentive regimes, and this applies for both renegotiations led by the firm and those led by the government.52 A further empirical result found in the study of renegotiations in Latin America is that partial public financing of the firm reduces government-led renegotiation but increases instances of firm-led renegotiation. The reduction of government-led renegotiation is consistent with traditional theory arguing that greater government ownership discourages the expropriation of profit by increasing the weight politicians put on the firm’s rents. Similar theory also suggests government commitment may be improved if the company is financed by loans rather than equity since debt financing increases the minimum return that the government has to allow.53 The modeling of limited enforcement above then adds to this argument by helping to explain the increase in firm-led renegotiation. If the government puts a higher weight on the firm’s rent, then they will have less of an incentive to increase enforcement and prevent the firm renegotiating.54 How public

52 See Guasch, Laffont, and Straub (2007, 2008). 53 See Enrico C. Perotti (1995) for the result on govern-

ment ownership and Yossef Spiegel and Daniel F. Spulber (1994) for debt financing. 54 See Guasch, Laffont, and Straub (2006) for this analysis. Furthermore, Luis Corria da Silva, Estache, and Sakari Järvelä (2006) argue that greater debt financing is inappropriate for LDCs due to the associate foreign exchange risk.

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financing of the firm may be used to solve commitment problems will therefore depend on which aspect is the greater risk in a given developing country. A different type of solution commonly advised by practitioners is to increase the independence of the regulator.55 One possible reason that independent regulation may increase commitment is that then the regulator may hold a different objective function from the government. This can be modeled in the same way as we have modeled an unaccountable government, i.e., we can suppose that the independent regulator has the objective function W = V + γ U rather than W = V + U. If the regulator is biased toward the firm (γ  > 1) and is given control over regulatory policy, then this works in a similar way to the “conservative central banker” idea used in monetary policy.56 The independent regulator will then be less keen to renegotiate than the government since they will care less about reducing the firm’s profit. Furthermore, a regulator with this objective function will encourage investment, as incentives will be more powerful (from equation __ (9)) and, hence, ​_U​ _  − ​U ​ will be larger. These results are supported by empirical literature showing the beneficial effects of independent regulation on commitment and investment.57 If limited enforcement is the most pertinent commitment problem, an independent regulator biased towards consumers could be helpful in a similar manner. Finally, Laffont notes that in developed countries commitment may be deliberately

55 According

to Estache (2008), by 2004 two-thirds of LDCs had introduced some form of independent regulatory agency in telecoms sector, 54 percent in electricity, and 23 percent in water. Witold J. Henisz, Bennet A. Zelner, and Maruo Guillén (2005) and Jordi Gual and Francesc Trillas (2006) study motivations for creating independent regulators. 56 See Kenneth Rogoff (1985). 57 Using cross-country evidence, Guasch, Laffont, and Straub (2007, 2008) find that the existence of an

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limited in order to prevent a nonbenevolent government binding the country to a bad outcome. By retaining flexibility, a future government can correct the mistakes of previous ones, and this may suggest that the existing lack of complete commitment powers is in fact optimal.58 In developing countries, where accountability is more limited, the chance of the government being nonbenevolent is higher. We may, therefore, reason that commitment should be more limited in LDCs as a result—i.e., limited commitment is not necessarily a problem but, in fact, is a solution to the accountability problem. However, it is important to note that the optimal level of commitment is not always increasing in the level of accountability. If, for example, governments are always nonbenevolent, then there is no probability of a future correction and, hence, commitment should be allowed in order to increase investment. In developing countries, where investment is so vital and commitment abilities already generally weak, increasing a government’s powers of commitment is likely to be a positive move. Overall, limited commitment comes in several different forms, and each may cause different problems and call for different solutions. In particular, biasing regulation toward the firm in some way may be sensible in countries where government ­noncommitment is the binding problem, but unadvisable if the enforcement of contracts is weak. In addition to this insight, Laffont’s framework allows us to understand the success of two ­independent

regulator does decrease renegotiation while in telecoms, Wallsten (2001), Luis Hernando Gutiérrez, (2003), Agustin J. Ros (2003), Maiorano and Stern (2007), and Miguel Á. Montoya and Trillas (2007) each find that independent regulation increases network expansion. 58 For more details, see chapter 16 of Laffont and Tirole (1993). Antoine Faure-Grimaud and Martimort (2003) also provide a model where commitment increases the damage caused by nonbenevolent governments. Pranab Bardhan (2005, pp. 68–74) considers the accountability/ commitment trade-off in reform more generally.

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Estache and Wren-Lewis: Toward a Theory of Regulation for Developing Countries 749 s­ olutions that emerge from developing country ­experiences, namely less powerful incentives and independent regulators. 2.6 Limited Fiscal Efficiency 2.6.1 Problems In the baseline model above, we defined the parameter λ to be the opportunity cost of public funds. In developing countries, where tax systems are often extremely inefficient, this cost is likely to be much greater: Laffont (2005, p. 2) reports that it is well beyond 1 in many developing countries, as opposed to something like 0.3 in developed countries.59 Such a significant difference has profound implications for regulation in LDCs. We have already seen that it is likely to worsen problems of limited accountability since the cost of incentive payments to the regulator becomes higher. Limited fiscal efficiency is also clearly a fundamental barrier when considering solutions to limited regulatory capacity and building institutions that will enforce commitment. Equation (4), which specifies the optimal pricing of the firm, tells us that the price markup should be greater the higher the opportunity cost of public funds. Hence, more limited fiscal efficiency unambiguously leads to higher prices faced by consumers when there is the possibility of transfers. This is because taxing the firm represents a relatively efficient way of raising government revenue, given the general fiscal inefficiency in the economy.60 The possible implication is that sectors that are subsidized in developed countries should be taxed in LDCs. 59 Leroy P. Jones, Pankaj Tandon, and Vogelsang (1990) and Emmanuelle Auriol and Michael Warlters (2007) estimate this cost for various countries. 60 This is an example of a traditionally inefficient tax being optimal in developing countries, as explored in Roger Gordon and Wei Li (2009). See Robin Burgess and Nicholas Stern (1993) for a survey of taxation in LDCs.

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As well as government transfers paying to cover fixed costs and maintain regulatory agencies, they have also traditionally been used to increase the size of the network. While in developed countries the vast majority of the population has access to centralized networks, the need in developing countries for rapid expansion of access is urgent. It is the limited fiscal efficiency of LDCs that makes the problem of access significantly different from developed countries. Many rich countries also have policies designed to encourage universal access to networks, but the relative budget required is extremely small in comparison. A good estimate is that the infrastructure expenditure requirements for low income countries are at least 9 percent of GDP, more than twice the needs of middle income countries.61 The challenge is all the more demanding since the geography of many poor countries means that utilities often cannot exhaust economies of scale to the extent that firms in developed countries are already able to do. We can demonstrate the problems associated with limited access by extending the model to consider two regions—a rich one (region 1) and a poor one (region 2)—each with a unit mass of consumers.62 We assume that the network is completely developed in the first region but only a share θ are ­connected in the second. We ignore problems of asymmetric information by assuming the marginal cost in each region is public knowledge and exogenous. Let Fi, ci, qi, and pi be the fixed cost, marginal cost, quantity per capita, and price in region i. Suppose the fixed cost in region 2 is a function of the share of people

61 See World 62 This is a

Bank (2005). modified version of the models considered in Laffont and Ake N’Gbo (2000) and chapter 6 of Laffont (2005) with the latter based on Estache, Laffont, and Zhang (2006). Laffont and N’Gbo (2000) additionally allow for an alternative technology in the poor region and varying quality, while Estache, Laffont, and Zhang (2006) consider the effects of asymmetric information and collusion in the two-region case.

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connected, i.e., F2 = F2 (θ), and that the cost is increasing in the size of the network (i.e., the cheaper areas are ­connected first), so F2′(θ) > 0 and F2″(θ) > 0. Let us further assume that that there is unit elasticity of demand. The optimal size of the network is then given by (10)  (1 + λ) F′(θ)

= S(q2) + λ p2 q2− (1 + λ) c2 q2.

Differentiating this equation by λ, we obtain dθ/dλ < 0. This shows that as fiscal efficiency becomes more limited the optimal size of the network decreases. Hence, in the poorest countries where network expansion is most needed, the opportunity cost of public funds prevents governments from being able to connect poor users. 2.6.2 Solutions Let us return temporarily to consider ways to mitigate the problems of limited fiscal efficiency in the model with asymmetric information and one region. If transfers between the government and the firm are permitted, then any expected rent that the firm receives will effectively come from government revenue. Equation (7), which specifies the effort level of the high-cost firm, shows us that a greater value of λ implies it is optimal for the government to use less powerful incentives. This is because transferring rent to the firm and the regulator becomes more costly for society as the taxes raised to pay these transfers become less efficient. Hence, the government prefers to decrease the efficiency of the high-cost firm in order to lower the rent going to the low-cost firm. This is, therefore, another reason why we might expect the power of incentives should be lower in LDCs. In developing countries, there still exist a multitude of price restrictions that are used to reduce high prices in costly areas. A common example is incumbent firms being compelled to charge the same price in

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r­ elatively sparse rural areas as in cities. Let us consider such a restriction in the model with two regions, symmetric information and unit elasticity and consider the case where the poor area has a higher marginal cost than the rich one, i.e., c2 > c1. Then in this case uniform pricing serves to decrease prices in the rural area, since we now have p2 = (1 + λ)(c1 + c2 θ)/(1 + θ) rather than p2 = (1 + λ) c2. However, we can note from equation (10) that a lower price in the poor area will result in decreased network expansion. Hence, there exists a trade-off between affordability and access. This is illustrated by the Chinese government’s adoption of a policy of uniform pricing in telecoms in 2001. Although the reform decreased the price discrimination that previously penalized rural users of the network, it also reduced the expansion of the network into rural areas.63 One way to mitigate the lack of public funding for network expansion is to institute cross-subsidies from the rich region to pay for greater access in the poor region. Let us consider the case where there are no transfers between the government and the firm. The government can mandate the firm to expand the network into the poor area through a “universal service obligation”—i.e., an obligation to serve a specified population. Then solving the government’s optimization problem gives us μF′(θ) = S (q2) + (μ − 1) p2 q2 − μc2 q2, with μ the coefficient on the firm’s budget constraint. When fiscal efficiency is very ­limited, we will have 1 + λ > μ and, hence, from equation (10) we can see that cross-subsidies achieve a greater amount of network expansion than public financing.64 This condition 63 See Estache, Laffont, and Zhang (2006) for details. 64 A more sophisticated analysis is provided in Farid

Gasmi, Laffont, and William W. Sharkey (2000), who develop an engineering process model of a competitive telecoms sector and provide conditions for when urban-torural cross-subsidies are a useful mechanism for funding universal service. They find that, unlike in developed countries, these conditions are likely to hold for many LDCs.

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Estache and Wren-Lewis: Toward a Theory of Regulation for Developing Countries 751 is likely to be met in many LDCs, and here cross-subsidies should be encouraged as the most efficient way to bring consumers onto the network. In summary, limited fiscal efficiency generally implies that the governments of developing countries should subsidize firms less (and tax them more) than in developed countries. The result will be high prices and small networks. To mitigate the effect of this on the poor, cross-subsidies may be the best option in many developing countries.65 When designing such subsidies, it is important to bear in mind that there is a fundamental trade-off between increasing access and increasing affordability. 3.  Extensions and Critiques The previous section has summarized some of the key insights from Laffont’s work on regulation in developing countries. We have shown that the model used by Laffont succeeds in providing lessons on the problems and solutions related to each of the four key institutional limitations LDCs face. However, as Laffont (2005) states, “the results should be considered as only a first step towards a more comprehensive theoretical framework” (p. xx). Indeed, practitioners’ experiences tell us that there are many important omissions from the model above. The aim of this next section is to consider how the theoretical work of other economists has filled some of these gaps. We proceed as before by considering the four institutional limitations that we believe are the most pressing concerns for regulatory policy in LDCs. The work considered

65 Indeed, cross-subsidies have historically been used in many developed countries as a means of resolving distributional concerns. Such subsidies still often exist in these countries’ telecommunications sector—see, for example, Robert W. Crandall and Leonard Waverman (2000) for further details.

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in each part includes various extensions and modifications of the model used by Laffont that other authors have made. Moreover, we also draw on literature that has taken an alternative theoretical approach when we find the framework of Laffont unsatisfactory. This review enables us to build a greater understanding of the robustness of Laffont’s model and the next steps needed to be taken in order to construct a more comprehensive theoretical framework. 3.1 Limited Regulatory Capacity Within the framework of Laffont’s models, we have concentrated on asymmetric information as the key way in which to model limited regulatory capacity. While this illuminates some of the problems of limited capacity, there are other aspects that are not purely based on concerns of information asymmetry. For example, in a recent survey of regulators in LDCs, 44 percent conceded that they did not have a good understanding of the different ways of regulating profits and prices.66 Such a lack of educated professionals and relative inexperience of regulatory bodies may be better captured by considering the limits of the regulator’s cognition and rationality. A key result of the regulator’s limited cognition is that there will be contingencies that are unforeseen when the contract is being drawn up. This is compounded by the lack of funds to pay lawyers and consultants who might be able to advise on such ­contingencies. We would, therefore, expect that more ­limited ­regulatory capacity will lead to a more incomplete regulatory contract. A contract is described as “incomplete” if it is not contingent on all the possibilities

66 This result is from Kirkpatrick, Parker, and Zhang (2005).

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that it would optimally be.67 Contracts are likely to be incomplete in developed countries also but, in developing countries, the problem moves from a relative side issue to center stage. One piece of evidence for this is that complaints over “lack of clarity” are much more frequent in the developing country context. Once we recognize the incompleteness of the regulatory contract, we are forced to move away from the (relatively) complete contracting model of Laffont. The incompleteness of the regulatory contract is made even more damaging by the greater uncertainty that exists within developing countries. For example, one contingency that was not included in regulatory contracts is the 1997 East Asia crisis. This resulted in such a dramatically widespread exchange rate crisis that almost all major infrastructure contracts in Asia had to be renegotiated simultaneously. Even though contracts had clauses relating to the exchange rate, such large changes were not envisaged at the time of writing and hence it was not possible to proceed without renegotiating. When a contingency not envisaged by the contract arises, bargaining will occur over how the contract should be changed (­assuming that it is in the interest of both parties to change the contract). In addition to the bargaining inefficiencies already discussed, the expectation of the process may reduce the incentives of the parties to invest or exert effort efficiently—the so-called 67 Tirole (1999) describes incomplete contracts as being caused by three transaction costs: the cost of foreseeing future contingencies, the cost of writing them into contracts, and the cost of then enforcing these contracts. Each of these is clearly applicable within the regulatory context. Furthermore, Maskin and Tirole (1999) show that some bounded rationality is required to motivate incompleteness, else contracts could be drawn up based upon the assumed probability distribution over agents’ payoffs. See Oliver D. Hart and John Moore (1999) and Ilya Segal (1999) for further discussion on the foundations of incomplete contracts.

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“­hold-up” problem.68 The typical hold-up problem in regulation is that the firm will not invest if they fear a future renegotiation will give them an insufficient return on the investment. Thus, the reduction in contractual completeness caused by limited regulatory capacity may prevent much needed investment. A further result of this contractual incompleteness is that the firm is likely to earn a greater expected rent. This occurs for two reasons. First, the government’s bargaining power is likely to be weaker ex post than ex ante since finding an alternative supplier is more difficult mid-contract.69 This shift will be particularly strong in developing countries since here utilities are often one of the greatest forms of foreign investment. If a private investor pulls out mid-contract, then this will send a large negative signal to markets, reducing much needed future FDI. Second, since writing contingencies into contracts is costly, the process of making a contract more complete will involve rent seeking.70 Both parties will try to make sure that contingencies that would put them in a bad bargaining position are included in the contract. Since the limited capacity of the regulator is not likely to be matched by the firm, contracts will be incomplete in a biased sense—i.e., the contingencies that are not included will be those where the firm has a greater ­bargaining power. The ­regulatory contract should therefore take account of 68 See Williamson (1975, 1985) for details of the holdup problem and its relationship with transaction costs. Note that while incompleteness may result in the renegotiation of the contract, it does not necessarily imply limited commitment in the sense that we have previously considered, because parties may not be able to commit to actions in states of the world which they did not foresee. 69 Williamson (1985) describes this change from ex ante competition to ex post monopoly as the “fundamental transformation.” The high risk of future renegotiation further undermines the classic argument of Harold Demsetz (1968) that regulation is unnecessary due to competition for the contract. 70 Hence, we may get a contract that is “too complete.” See the model of Tirole (2009) for this analysis.

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Estache and Wren-Lewis: Toward a Theory of Regulation for Developing Countries 753 this expected positive rent a firm will earn from unforeseen contingencies. Taking the contractual incompleteness into account may also have implications for the optimal power of incentives that are not considered in the model above. Suppose an unforeseen contingency occurs that results in a change in the firm’s marginal cost. Under a contract where a proportion of the firm’s costs are reimbursed, costs will be monitored and renegotiation should be fairly straightforward. On the other hand, under a high powered fixed price contract, there is no direct need for the government to collect data on the firm’s cost. In developing countries, reliable cost accounting may, therefore, not occur. Hence, under a pricecap regime, there will be a greater amount of relevant asymmetric information between the firm and the government. Since asymmetric information means there will be a higher chance of breakdown in bargaining, renegotiation to a new price-cap regime has a greater expected cost. Therefore, as limited regulatory capacity will lead to less complete contracts in LDCs, this mitigates in favor of starting off with less powerful contracts.71 A further suggestion from the incomplete contracting approach is that efficiency may be retained if the parties can at least fix ex ante their respective bargaining powers and default positions for future renegotiations.72 In regulatory contracts, this may be best done through an arbitration process. Bargaining

Laffont’s work on limited accountability concentrated on the ability of the regulatory

71 This is modeled in Patrick Bajari and Steven Tadelis (2001) in the case of construction contracts. In the case of utility regulation, Guthrie (2006) indeed argues that price caps based on a hypothetical benchmark firm should be avoided when capacity is limited due to informational requirements. 72 See, for example, Philippe Aghion, Mathias Dewatripont, and Patrick Rey (1994). M’hand Fares (2006) provides a general survey of contract solutions to the hold-up problem. Hart and Moore (1988) argue that a key problem is that such mechanisms may rely on being able to identify the party that caused the renegotiation, which is often difficult to prove to a third party.

73 Estache and Lucia Quesada (2001) show how the government may wish to balance renegotiation bargaining powers to improve welfare. Alfredo Garcia, James D. Reitzes, and Juan Benavides (2005) show that the government can mitigate the commitment problem by having a litigation fund which it commits to using in event of renegotiation. 74 For example, a contract may specify different actions for two states of the world that a well-resourced regulator, backed by an experienced judiciary, could distinguish between. However, capacity constraints may make these two states indistinguishable and, hence, the contract will be vague for all practical purposes.

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power could, for example, be determined by setting up an expert panel with an appropriate bias, or through the creation of a litigation fund.73 One may also be able to change the default positions through the use of fines or international guarantees. To summarize, it is essential to recognize the limited cognition of the regulator as an aspect of limited regulatory capacity additional to the informational issues studied by Laffont. The transaction costs involved in writing contracts and the resulting incompleteness have implications for the optimal design of the regulatory contract. Contracts that are relatively complete in developed countries may be incomplete in developing ones and, hence, this emphasizes the danger of importing best-practice models.74 Contractual incompleteness may decrease investment and increase the firm’s rent, but these effects may be mitigated by anticipating future renegotiation and implementing policies to make it relatively fair and efficient. However, there has been relatively little work applying the ideas from the theory of incomplete contracts to the case of regulation. More work is needed in order to help ­policy makers understand the full consequences of the limited regulatory capacity and greater uncertainties present in developing countries. 3.2 Limited Accountability

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agency to hide information from the government. The model gave us a number of important insights, but we noted that, in developing countries particularly, we are also worried about the limited accountability of other actors. Hence, it is necessary to consider how far Laffont’s framework can be extended to help us understand other types of corruption. While the model set out above has a threetier hierarchy of government/regulator/firm, it can be adapted to consider other circumstances. For example, decentralization of regulation has been a popular idea among international advisers to LDCs, and this can be studied by considering the hierarchy of central agency/local agency/firm. In this setting, it may be in the interest of a local regulator to collude with the firm by hiding information from a centralized administration. In China, for example, local governments have been known to collude with small-scale inefficient coal power plants in order to prevent them being shut down by the central government. This is because the local government has an incentive to keep power plants in their region open as they provide jobs and tax revenue, which aid the local officials’ personal objectives such as promotion.75 More generally, if the central administration shares costs with the local regulator, then the local regulator has an incentive to collude with the firm to exaggerate the value of a project. In this case, the central regulator may have to reward the local regulator for reporting low costs, in a similar way to the model above.76 A further extension of the regulatory capture model is to use the framework to understand the unaccountability of the government to its citizens. This may help us to understand the importance of the public’s 75 See Laffont 76 The model

(2005, pp. 22–24) for further details. of Martin Besfamille (2004) considers such a situation in the case of public works. Bardhan and Dilip Mookherjee (2006) construct a general model of accountability for the case of decentralizing publicly operated infrastructure.

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perception of corruption. Experiences in developing countries suggest that, even if a reform is welfare enhancing, it may lose support from the populace if corruption is seen to have increased. This is a potential explanation for the dissatisfaction with ­privatization in Latin America, where surveys reveal that increasing discontent with privatization is correlated with increasing perceptions of corruption.77 This correlation may be explained by modeling an alternative hierarchy of general public/government/firm, which focuses on the limited accountability of the government to its electorate. Suppose a key change resulting from privatization is the removal of transfers between the government and the firm. Collusion under public ownership results in an additional government transfer to the firm while, under private ownership, it will take the form of higher prices. If the cost of public funds is sufficiently higher than the cost of raising prices, corruption will be less costly and, hence, more frequent under private ownership. Since the high cost of public funds in LDCs makes this condition quite likely to hold, this suggests privatization may increase corruption.78 Furthermore, in developing countries, where fiscal accounts are likely to be opaque to most citizens, ­revenue raised through prices is less likely to go unnoticed than budget transfers. This extension continues to model collusion in the form of hiding information, as did the decentralization application. While this is an 77 This explanation and evidence is from Martimort and Straub (2009). 78 This analysis is from the model of Martimort and Straub (2009). Other literature, such as Maxim Boycko, Andrei Shleifer, and Robert W. Vishny (1996) and Sappington and Joseph E. Stiglitz (1987), has argued that privatization limits the nonbenevolent behavior of the government. See Martimort (2006) for a survey of the costs and benefits of privatization. More generally, Acemoglu and Robinson (2008) show how de jure institutional changes such as privatization may not result in de facto changes in power or policy.

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Estache and Wren-Lewis: Toward a Theory of Regulation for Developing Countries 755 important aspect of unaccountability, there are many other decisions that are open to corruption.79 In addition to the ­privatization choice analyzed by Laffont, the government or the regulator will make decisions including the amount of competition to allow in the market, who to sell the enterprise to, and the permitted profit. Each of these decisions is vulnerable to influence by the firm or other interest groups.80 Distinguishing between different types of corruption is important in deciding upon the appropriate solution. If corruption takes place in the bidding for a contract, increased accountability in the bidding process may prevent an inefficient yet well-connected firm from winning. On the other hand, if corruption takes place between the firm and the regulator postcontracting, then the same firm may win the contract in a completely fair auction.81 In the model of section 2, we represented the decisions made in such cases as the ­solution of a nonbenevolent principal maximizing the welfare function (8), with the weight γ dependent on the influence of the interest groups. However, this does little to illuminate why some interest groups have 79 See Charles Kenny (2009) for a general survey of corruption in infrastructure. One form of corruption we do not discuss here is that between the utility and the users, on which little work has been done—Clarke and Lixin Colin Xu (2004) is one notable exception that uses data on the paying of bribes to utilities. 80 For example, Armstrong and Sappington (2006) note that introducing competition may require entry assistance, which can encourage regulatory capture and unproductive use of public funds, while Bjorvatn and Søreide (2005) argue that, if firms bribe for licenses, then the government will choose a less competitive environment. Gene M. Grossman and Elhanan Helpman (1994) create a general model where interest groups bid for their preferred policy. Dal Bó (2006) provides a survey of regulatory capture in general. 81 This example comes from Dixit (2003). As an example of considering different forms of corruption, Joel S. Hellman, Geraint Jones, and Daniel Kaufmann (2003) distinguish between “influential” firms, who affect rule making, and “captor” firms, who capture bureaucrats. They find that the two types of corruption are not equivalent and produce significantly different results.

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more power than others. For instance, why could farmers in the North of Argentina and parts of Peru manage to get regulators to adjust the pricing of energy they need to pump water while leather producers, also heavy users of pumped water, could not? Similarly, why are farmers who are responsible for a large share of many African countries’ output so much less powerful in their relation with utility regulators? The model of a single principal maximizing a weighted welfare function leaves little room to explore how the structure of government and the regulatory agencies influence the power of interest groups on policy.82 In the developing country context where the lack of accountability is widespread, it is, therefore, necessary to move beyond models with a single principal and instead consider the multiplicity of actors that exist within the government.83 The existence of multiple principals can aid accountability if they are under the influence of different interest groups with conflicting aims. Hence, one way of dealing with the risk of regulatory capture is to ensure that the selection process involves these different actors. An example advocated by practitioners is to include both the ­executive and the legislative branches in the regulator’s appointment.84 On the other hand, when different principals are affected by the activities of the bureaucrat–regulator, the latter can play one principal off against the other. The bureaucrat may then become less accountable with 82 Grossman and Helpman (1996) provide one way in which such weights can be made endogenous by considering campaign contributions to political parties. 83 The multiplicity of principals is one of the factors considered by Hussein Kassim and Catherine Waddams Price (2005) in the introduction to a special issue on the limits of the principal–agent model in regulation. 84 Dal Bó (2006) finds evidence of regulatory behavior depending on their appointment method. For other models describing the risks and benefits of multiple principals, see, for example, Martimort (1996) and Torsten Persson, Gerard Roland, and Guido Tabellini (1997)

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each principal unable to constrain its actions. Whether or not the existence of multiple principals is a curse or blessing for accountability depends on the regulatory process and structures in place.85 For example, one way to increase accountability is to expose the regulatory bureaucrat by making available private information on the effectiveness of the bureaucrat’s behavior. Simple institutional rules, like the public release of regulatory information, may allow this kind of information sharing between multiple principals. Furthermore, restrictions on the set of instruments available to the different actors may help to reduce their scope to extract rent or align the decisionmaker’s incentives. For instance, if the elected executive does not have power over the funding of the regulator, then the regulator will be less responsive to short-term political concerns. These aspects of regulatory governance with multiple principals also apply to some extent in developed countries. However, the key difference is that these factors are automatically considered in developed countries because here the regulatory framework comes about endogenously and the actors involved will be very aware of the influence of various interest groups. In ­developing ­countries, the risk is that these concerns are not taken into account because regulatory structures may be designed exogenously. Here the regulatory setup is partially constructed by international experts who are not automatically aware of the power of different principals within the government. Overall, we can see that the framework used by Laffont has the potential to explain many aspects of limited accountability in LDCs. Not only does it give implications for 85

See Mathew D. McCubbins, Noll, and Barry R. Weingast (1987), Spulber and David Besanko (1992), and Dixit (2003) for discussions on how the interaction of ­multiple actors in government is influenced by processes and structures.

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preventing regulatory collusion as discussed in the previous section, but it can be extended to consider the risks of decentralization and explain why corruption may increase with privatization. However, when external actors are advising on regulatory structures and processes in developing countries, they need to take account of the multiprincipal nature of government. Here it is, therefore, necessary to go beyond a model with a strict hierarchy of actors. 3.2 Limited Commitment The implications of a limited ability to commit go beyond those studied by Laffont. Since in developing countries the probability of renegotiation is so large, anticipation of possible renegotiation will play a major role in actors’ decisions. For instance, in the Buenos Aires water concession, the winning firm had taken out a loan that, without renegotiation, it would not have been able to repay.86 While Laffont focused on the problems after a particular firm has been chosen to contract with the government, limited commitment may also affect the auction process and the viability of reform. Argentina also provides a good example of the effect of limited commitment on bidding for contracts. In selling an electricity contract, the government announced a change in the regulatory framework a few days before the auction, offering a higher rate of return and an extension to the contract length. This was expected to increase the value of the contracts but, in fact, it is believed that the amounts bid were less as a result. This is because it heightened fears that the government was willing to alter the regulatory framework at short notice.87 Hence, a 86 This example comes from Lorena Alcazar, Manuel A. Abdala, and Shirley (2002). 87 See Luigi Manzetti (1999) for this example. Bernardo Bortolotti and Domenico Siniscalco (2004) also find evidence that privatization revenues increase with measures of government commitment.

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Estache and Wren-Lewis: Toward a Theory of Regulation for Developing Countries 757 lack of faith in promised future returns may decrease the amount bid. This effect on bidding raises the possibility of adverse selection in auctions. The contract may not go to the most efficient firm, but instead to the one that believes it has the highest chance of renegotiating (or the lowest chance of expropriation). This issue was raised as a matter of concern by Argentina’s National Public Auditor during the 1990s for several of the contracts awarded to toll roads operators. From the government’s point of view, it also may want to bias the awarding of the contract to pick an inefficient firm if they have a lower chance of renegotiating.88 The fear of actors not living up to their promises may also undermine support for reform.89 For example, large-scale sector reforms have often commenced with price rises in order to allow the firm to recover a greater proportion of its costs. This is planned to enable the firm to make investments in cost reduction, which in the long term should benefit users if translated into reduced prices. However, consumers are often suspicious that these promises will not be met and, hence, attempt to derail the reform. The Mali privatization discussed in the introduction is a good example of this process. Thus, even if the overall reform could result in a Pareto improvement, the reform is not ­supported because the parties cannot commit to redistributing the gains appropriately. This is particularly troublesome in utility reform because the costs are

often felt immediately while it takes time to realize many of the gains. Let us now turn away from the further problems of limited commitment and move to consider in more detail a proposed solution for developing countries, namely ­regulatory independence. We have discussed previously how one may model the effects of independence in the framework of Laffont. However, many of the aspects of this policy emphasized by practitioners are not included in the model. Given the prominence given to this issue within the empirical literature and policy debate, it is necessary to take this analysis further. In practice, one method through which regulatory independence may aid commitment is by reducing the accountability of the regulator to political representatives.90 If there is a greater potential for collusion as a result of independence, then this will tend to favor regulatory regimes with less powerful incentives which, as mentioned above, may reduce commitment problems.91 Alternatively, if independence makes the decisionmaker more susceptible to firm lobbying, then this may give them a pro-industry bias that creates the appropriate incentives for investment.92 In some circumstances, increasing independence may therefore create extra space for this type of collusion and hence mitigate commitment problems. Further aspects of an independent regulator that practitioners argue may aid commitment include the fact that the regulator

88 Estache and Quesada (2001) explore this latter point in a model with alternating governments. 89 See Jose Edgardo Campos and Esfahani (2000), Acemoglu (2003), and Bardhan (2005). 90 There is some empirical evidence that independence interacts with corruption unfavorably. Estache, Goicoechea, and Trujillo (2009) find that the interaction of an independent regulator and high corruption levels has a number of negative effects on performance. Gual and Trillas (2006) find evidence suggesting incumbents may favor independent regulators, perhaps anticipating capture. Alternatively, incumbents may favor independent

regulators because they can commit to letting the firm keep information and efficiency rents. 91 Trond E. Olsen and Gaute Torsvik (1998) give this result. 92 See Yeon-Koo Che (1995) and Joanne Evans, Paul Levine, and Trillas (2008) for models in this category. David J. Salant (1995) gives a similar effect with the opening of the “revolving door” between careers in regulation and industry. David G. Victor and Thomas C. Heller (2007) argue that, in practice, limited commitment has led to the rise of “dual firms” that mitigate a lack of commitment by keeping close ties to the public sector.

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may be able to tie its hands in a way the government cannot or may hold a greater concern for its reputation.93 This multitude of ­different ways that regulatory independence may reduce commitment problems emphasizes the need to examine the concept of independence more thoroughly. In particular, there is a need to breakdown the various aspects of “independence” and consider which are likely to be more important and which are likely to have the greatest risks. For example, is removing the regulator’s budget from political control more important than having a staff of professionals that are not generalist civil servants? This is crucial for developing countries because political constraints mean that they may not be able to create entities that have all the aspects of independence immediately. While the empirical literature has begun to separate out aspects of regulatory governance, there is a lack of corresponding theoretical work. Progress in this area would help governments to define priorities when carrying out regulatory reform.94 The lack of complete regulatory independence in many developing countries motivates a more holistic approach to the government when considering commitment problems. In developing countries, power is often very concentrated in the executive, and this can be the root cause of many commitment problems. Even if the regulator is independent, a powerful executive may be able to undermine the agency since it ultimately 93 Reputational concerns are considered in Salant and Glenn A. Woroch (1992), Gilbert and Newbery (1994), and Levine, Stern, and Trillas (2005), while John Cubbin and Stern (2006) find evidence that the effect of good regulatory governance increases over time as a reputation is built up. 94 Gutiérrez (2003) considers different levels of independence amongst independent regulators, while Sheoli Pargal (2003) finds evidence in cross-country regressions that different aspects of independence may have different effects. Ashley Brown (2003) discusses the splitting of powers between policymakers and independent agents.

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decides upon regulatory policy. Here regulatory transparency may be costly if it weakens the power the regulator holds through being better informed than the executive. Concentrating solely on a single regulatory body is, therefore, likely to have limited effectiveness and it is worth considering other veto points or constraints on the executive. This might include a separation of powers through involving the judiciary or the legislature.95 Generally, a separation of powers improves commitment because future renegotiation is more costly when there are many noncooperating principals that have to agree to a renegotiation. Empirically this idea is verified by the existence of checks and balances having a positive effect on utility investment in LDCs.96 If it is possible to constrain the actions of the government through specific legislation or the judiciary, then this may be a superior method of regulatory governance to an unconstrained independent regulator. For example, in telecoms in Jamaica, the switch from a detailed operating license regime to one with an independent regulator in the 1960s was probably the cause of a following large decline in investment. This is because the operators feared the regulatory would misuse its discretion in a way that was not possible when the relatively specific license was enforced by the judiciary.97 The challenge is to design a regulatory process that increases commitment in a way that is compatible with the country’s institutional structure. An independent regulatory agency will work less well in a country where there 95 This framework is set up for regulation by Pablo T. Spiller (1990), Brian Levy and Spiller (1994, 1996), and Guasch and Spiller (1999). See also Tirole (1994) and William B. Heller and McCubbins (1996). 96 Using cross-country panels, Mario Bergara, Henisz, and Spiller (1998), Henisz and Zelner (2001), and Gutiérrez (2003) find investment in electricity and telecoms suffers when there are fewer checks and balances. 97 This example comes from Levy and Spiller (1994, p. 232).

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Estache and Wren-Lewis: Toward a Theory of Regulation for Developing Countries 759 is little tradition of bureaucratic autonomy. Here, if the legislator is fairly independent of the executive, specific legislation may instead increase commitment. If general separation of powers is not feasible, then the splitting up of regulatory roles may similarly increase commitment.98 This goes against the tendencies of policymakers in LDCs because generally it is easier to push through initial reform when there are fewer actors involved. Theoretically, therefore, the optimal regulatory charter is to start off with few actors (or at least all actors cooperating) and then to increase the number of actors as time progresses. Such a charter is likely to be infeasible. However, the more important result that practitioners may want to keep in mind is that the excessive splitting of the responsibilities of regulatory agencies may be good for regulatory outcomes. Laffont’s framework, therefore, only analyzes a subset of both the problems of limited commitment and the proposed solutions. In developing countries, limited commitment will cause problems at all points in the reform process. Furthermore, the origins of limited commitment are likely to be much more fundamental than in developed ­countries, ­stemming from a lack of separation of powers and checks and balances. Solutions must, therefore, go beyond the regulatory contract and take into account the processes and structures that define the framework as a whole. 3.3 Limited Fiscal Efficiency We have considered the problem of a high cost of public funds in the case where transfers are allowed in section 2.6. However, since the existence of transfers was exogenous to the model, it did not help to answer the ­question of why the existence of transfers 98 Olsen and Torsvik (1993) and Martimort (1999) give models showing that opportunistic renegotiation is decreased when there are several regulators.

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varies between countries and sectors and how this relates to fiscal efficiency. Making the existence of transfers endogenous may help us to understand the importance of transfers between the government and the firm. This is particularly pertinent since their existence tends to be linked to whether the firm is privatized and, hence, may help us to understand the costs and benefits of privatization. Suppose that the cost of allowing transfers is that this gives greater responsibility for production decisions to the government. As shown previously, this will be costly in the presence of asymmetric information. If the monopoly is very profitable and the cost of public funds is not too high, it will be optimal to remove transfers and let the firm run efficiently. However, when fiscal efficiency is very limited, transfers should be reestablished since high prices can be used to increase government revenue. The high cost of public funds may also push for less competition in order to increase taxable industry profits. Hence, we would expect to see a greater role for transfers and more stateowned monopolies in LDCs. This is indeed consistent with experience.99 This extension focuses on the fact that limited fiscal efficiency increases the cost of public funds, as does the framework used by Laffont. Another crucial aspect of limited fiscal efficiency that is not well captured in the model above is that redistribution amongst consumers is much more difficult in developing countries. Without effective redistribution, it is extremely important to distinguish between productive efficiency and Pareto efficiency since the concepts will be significantly different.100 For example, a ­simultaneous 99 This analysis is from Auriol and Pierre M. Picard (2009). Auriol and Warlters (2005) show more generally that it may be optimal for LDCs to put barriers on entry in order to increase the tax base. 100 See Daniel W. Bromley (1989) for further discussion on the link between institutions and the concept of efficiency.

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increase in prices followed by a decrease in taxes may increase overall “consumer welfare” in the model above, but in reality the winners and losers from such a change are unlikely to be the same. This explains why we might reject the conclusion in section 2.6 that prices should be higher in developing countries where fiscal efficiency is limited. Since poor consumers may be outside of the tax system but receive some utilities, lowering prices through government subsidies may be the optimal means of increasing their welfare. This was indeed the concern that prevented large price rises in the Mali reform detailed in the introduction. Once it has been accepted that there is a role for redistribution in regulation, there is a need to go beyond the two-region model used by Laffont and consider the distributive effects of policies on a more micro level.101 A crucial problem in developing countries is targeting subsidies toward those that need them. Since gathering data on poverty is difficult, a popular type of subsidy has been some form of increasing block tariff or a “lifeline” consumption quantity. Under such a pricing regime, each consumer is allowed a basic amount of the service for a reduced price and the marginal cost to the consumer then increases as consumption increases. This works on the premise that consumption is positively correlated with income, which appears reasonable. It is particularly appealing in LDCs because measuring service consumption is often significantly simpler than measuring income directly. However, poor households tend to be larger than rich ones and a service may be shared between many poor households. These factors will reduce the correlation between 101 Timothy Irwin (2003) and Komives et al. (2005) review the various options for subsidies in LDCs, while Trillas and Gianandrea Staffiero (2007) and Parker, Kirkpatrick, and Catarina Figueira-Theodorakopoulou (2008) provide surveys of the literature on regulation and redistribution/poverty.

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income and measured household consumption. It is, therefore, important to examine empirically the theoretical assumptions that redistributive policies are based on before implementation since their validity will vary between locations and sectors. For example, there is some evidence that the correlation between income and water consumption is significantly lower than that for electricity consumption. Moreover, in many developing countries, large proportions of the population do not have water meters. Since consumers are generally charged to install them, poor households are probably less likely to be metered than rich ones and, hence, are unable to take advantage of quantity based subsidies. This suggests that increasing block tariffs are likely to be more progressive in electricity than water.102 The introduction of competition also has implications for existing cross-subsidy regimes. In many developing countries, traditional cross subsidies that took place within a monopoly have been disrupted by the introduction of competition in the more profitable parts of the sector. Theoretically, these subsidies can be reinstalled through taxes on firms in the competitive sector being allocated to those operating in the subsidized area. This will require further administrative capacity and, in order to decrease conflicts of interest and collusion, these subsidies should probably be managed by a separate agency. The claim made by some policymakers that competition limits redistribution is probably not true.103 It does, however, add complications to schemes typically used in LDCs for

102 This result is from Komives et al. (2005). 103 In telecoms, for example, Wallsten (2001),

Carsten Fink, Aaditya Mattoo, and Randeep Rathindran (2003), Ros (2003), and Wallsten (2004) all find evidence in crosscountry regressions that competition increases network expansion in telecoms. Furthermore, exclusivity clauses discourage smaller-scale alternative providers that are not on the network, even though such providers often are the most realistic option for rural communities.

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Estache and Wren-Lewis: Toward a Theory of Regulation for Developing Countries 761 this purpose, such as price restrictions and universal service obligations. For example, the stipulation that prices be the same across the network will soften competition since the firm subject to such restrictions will be reluctant to lower its prices in the competitive part of the sector. This may then ­discourage an incumbent firm from expanding the network since the expected competition softening will make fighting entry more difficult. Furthermore, if subsidies for rural areas are auctioned, price restrictions will distort the bidding in favor of new entrants since they do not suffer the associated strategic disadvantage of serving these areas.104 Each of these results suggests that simple price restrictions may not be an appropriate tool for redistribution in partially competitive sectors. Similarly, universal service obligations that apply to the incumbent only are likely to be distortive, and it will generally be better to auction contracts to supply highcost areas.105 Finally, there is also a need to consider a positive approach to the theory of redistribution in developing country regulation. In the theory discussed so far, including that of Laffont, we have treated the motivation for subsidies either as exogenous or the result of some normative social welfare optimization problem. Such an approach misses many of the historical reasons for subsidies and is unadvisable since it does not take into account the need for political support

104 See James J. Anton, James H. Vander Weide, and Nikolaos Vettas (2002), Tommaso M. Valletti, Steffen H. Hoernig, and Pedro P. Barros (2002), and Hoernig (2006) for analyses of all these effects. On the other hand, as shown by Armstrong and Vickers (1993), allowing price discrimination by the incumbent may also give way to anticompetitive behavior. 105 See Philippe Choné, Laurent Flochel, and Anne Perrot (2002) and Helene Bourguignon and Jorge Ferrando (2007) for analyses of the potential problems of applying service obligations to incumbents only. Valter Sorana (2000) and Wallsten (2008) give surveys of issues related to the auctioning of subsidies.

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for reform. One of the greatest mistakes of reformers in many developing countries has been to press for efficiency enhancing cost recovery without sufficient consideration for making sure that the gains of reform are seen to be spread fairly. For example, the removal of inefficient subsidies has in many countries led to sharp price increases and the resulting unrest has derailed the reform.106 While in the long term it is obviously preferable to move toward the normative paradigm, political constraints must be constantly borne in mind. To summarize, the basic modeling of limited fiscal efficiency by Laffont is a starting point for considering its influence on regulation in LDCs but the analysis needs to go further on many issues. The need to consider distributional issues explicitly across regulatory policy has been accepted by practitioners and theoretical work is beginning to catch up by considering the implications of privatization, competition, and pricing for redistribution. It is important that this work comes from both a normative and a positive angle, because in developing countries these policies have a crucial impact on both poverty reduction and support for regulatory reform. 4.  A Future Research Agenda The last section has outlined various ways in which the work of Laffont has been extended as well as criticisms that show the limitations of the approach of the model above. This input has moved us one step closer to the comprehensive framework that Laffont sought. However, there is still a way to go before the theoretical tools developed for LDCs are as developed as those focusing on the key issues that richer countries face. In this section, we 106 See Rudiger Ahrend and Carlos Winograd (2006) for a political economy analysis of how the effectiveness of the tax system impacts upon support for privatization.

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suggest an agenda for future research in the area that will help to build a general framework for regulation in developing countries. The analyses discussed above have provided us with many solutions for the problems that arise due to the four key institutional weaknesses. However, we have frequently seen that the implications for policy have been contradictory. For example, greater public financing of the firm may help the government commit not to expropriate, but will reduce their willingness to enforce the original contract. Deciding which holds the greatest risk, government expropriation or firm-led renegotiation, is difficult to evaluate without a framework that analyzes this trade-off explicitly. Furthermore, one institutional weakness may push for one solution while another calls for the opposite. This is unhelpful given that most developing countries suffer several of the weaknesses simultaneously and, therefore, the policy choice is not obvious. For example, a lack of regulatory capacity favors creating as few agencies as possible in order to make best use of limited human capital. On the other hand, we have seen that there are theoretical benefits of having multiple principals in terms of increasing commitment and accountability. Practitioners have tended to favor multisectoral agencies, judging that the former is the most pressing concern. However, there is no theoretical framework that allows us to compare the costs and benefits of this option, so we cannot evaluate what assumptions are implicitly being made. There is, thus, a need to develop models that take into account trade-offs between mitigating one institutional weakness and another. This may help to clarify exactly where potential trade-offs lie—for example, which aspects of regulatory governance might sacrifice accountability for commitment, and which ones may be able to improve both? Empirical work suggests that independent regulation increases ­investment,

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but how are we to tell whether this occurs due to greater commitment powers or the offering of ­excessive returns due to regulatory capture?107 Furthermore, analyzing the trade-offs explicitly will create criteria for when the costs of one policy outweigh the benefits, which will help guide empirical work. Ultimately, optimal policy will vary between countries and, in any particular situation, should be based on a diagnostic of the institutional environment.108 A next step required from the theoretical work is, thus, to develop a mapping from this diagnostic to an advised policy set. A good starting point may be to combine two models from above that explore different institutional weaknesses and consider how they interact. As well as the optimal regulatory policy being dependent on the country, it will also change over time as the country moves along its development path. This dynamic element has been largely absent from the models discussed, where even if interactions are repeated the institutional context is assumed to be exogenous and constant over time. In reality, regulatory outcomes are likely to feed back into the surrounding environment and this will affect future optimal policy. For example, a newly created independent agency may lack the credibility, power, or capacity to carry out many regulatory tasks. Loading it with many decisions may result in its failure. If it is instead given a small number of basic tasks that it executes successfully, this may increase its future ability and allow for it to 107 For example, Henisz and Zelner (2006) use crosscountry panel data to show that a more powerful industry lobby reduces investment in SOEs generating electricity and argue this is evidence that inefficient “white elephants” are prevented. On the other hand, also using cross-country panel data, Cubbin and Stern (2006) show that independent regulation increases investment in electricity utilities, and they argue this shows the positive effects of commitment. While both interpretations may be correct, the contrary may also be the case. 108 See Rodrik (2008) for a discussion of this approach to development in general, with a focus on growth.

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Estache and Wren-Lewis: Toward a Theory of Regulation for Developing Countries 763 gradually become completely independent. Ultimately, incorporating a dynamic element into models of regulation may allow the framework to tie together theory for LDCs with that for developed countries. One way to go about this may be to add elements from general theories of institutional change into the regulatory framework detailed above. In our review, competition has been suggested in several places as a potential way of mitigating the regulatory problems caused by institutional limitations. However, competitive markets in developing countries suffer from greater information deficiencies and a smaller size than in developed countries, and there is also a difficulty in raising local capital and attracting foreign investors.109 Moreover, many of the institutional weaknesses outlined above will also impact on competition. For example, limited regulatory capacity weakens antitrust agencies and corruption may facilitate collusion and reduce entrance.110 There is, therefore, a need to understand better the relationships between these market problems and the institutional limitations discussed in order to give better advice on the decision of liberalization.111 More generally, it is important to note that most of the work of Laffont detailed above has taken a normative approach, aiming to find the desirable policy set for governments in LDCs to implement. We have mentioned empirical evidence suggesting that, in some cases, governments indeed appear to follow the models’ implications—for instance, governments whose commitment ability is weak are found to be more likely to create

109 This point was suggested by one of the referees. 110 See Alberto Ades and Rafael Di Tella (1999) for

a theoretical and empirical analysis of the effects of corruption on competition. 111 Armstrong and Sappington (2006) provide a thorough survey of the existing work on the pros and cons of liberalization in general.

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i­ndependent regulators.112 We have also seen that in other cases this is not true—an example is the low prices that have often been set by state owned enterprises in situations where such a policy is both inefficient and regressive. However, little empirical work has tested directly whether or not governments set regulatory policy as normative theory tells us they should. This is increasingly possible as data availability improves and the implications of theoretical models become more precise.113 In many situations, such testing is likely to find that governments do not behave as the normative theory recommends. In this case, a positive theory of regulation may be better at explaining regulatory policy and outcomes. Positive theories of regulation already exist but they may need some adaptation in order to explain outcomes in developing ­countries.114 The survey above has included some theory that analyzes regulation in LDCs from a positive angle but, generally, work in this area has been sparse. Further development of this approach should go alongside future ­empirical work. One advantage of understanding better why governments in LDCs implement the regulatory policy they do is that this will feed back into improving empirical work that attempts to measure the effects of these policies. Finally, it should be noted that economic research on regulating utilities has been largely skewed toward privately operated firms despite the fact that the regulation of 112 This result is found in cross-country regressions by Gual and Trillas (2006). 113 Dal Bó and Rossi (2007) and Andres et al. (2008) are two recent examples of how, as data becomes available, new research can generate useful tests of some of the theories discussed in this survey. 114 See, for example, George J. Stigler (1971) and Sam Peltzman (1976) for classic positive approaches to the theory of regulation. More generally, Timothy Besley (2006) provides a detailed analysis of why governments may not be benevolent welfare maximizers and analyzes a theoretical framework that starts from this basis.

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publicly run enterprises is a common phenomenon in LDCs.115 We have not excluded the regulation of publicly operated utilities from this survey but the focus on private firms has been dictated by the literature. Partly this has stemmed from the belief that privatization has been a necessary step to get countries to set up serious regulatory agencies. While this has been true in some cases, there are clear counterexamples—in a recent survey of electricity regulators in Latin America and the Caribbean, Trinidad and Tobago was found to have the best governance rating, despite it regulating a state-owned enterprise.116 The danger is not only that the absence of knowledge in this regard may lead to inappropriate regulation but also that advisers may be overly keen on private participation simply because of their greater familiarity with the regulation of private firms. There is, thus, an urgent need for further work considering the differences between regulating privately and publicly operated enterprises.117 5.  Conclusions Experiences in developing countries over the past two decades have shown us that the effects of institutional limitations on regulatory outcomes can be large. When institutions are weak, solving the related problems will be more important than resolving the 115 The African Forum for Utility Regulation (2002) estimates that half of all regulated utilities are stateowned, while Estache (2008) reports that, by 2004, 40 percent of LDCs had no significant private sector participation in their telecoms industry and 60 percent had none in electricity and water. 116 See Sebastian Lopez Azumendi et al. (2007). 117 José A. Gómez-Ibáñez (2007) and Maria Vagliasindi (2008) are examples of recent theoretical work on this area. Empirical comparisons of public and private utilities include Estache and Rossi (2002), Kirkpatrick, Parker, and Zhang (2006), and Clarke, Katrina Kosec, and Wallsten (2009) in the water sector and Sanford Berg, Chen Lin, and Valeriy Tsaplin (2005) and Andres et al. (2008) in electricity.

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concerns that are normally stressed in the regulation of utilities in developed countries. This underlines the importance of building a theoretical framework that has institutional failures at its heart. We argue that such a framework needs to take into account four key institutional weaknesses: limited regulatory capacity, limited accountability, limited commitment, and limited fiscal efficiency. Using Laffont’s work as a springboard, this article has aimed to isolate where these institutional weaknesses found in developing countries matter and what the appropriate response should be. Several implications arise from our review as to how regulatory policy should be different in LDCs. In terms of the power of the incentive scheme, fixed-price contracts will be the only option when limited regulatory capacity means the observation of costs is unreliable. Once regulatory capacity is less of a constraint, incentives should be less powerful the weaker the institutions. A further implication is that some separation of regulatory powers is ­necessary in order to counter problems of limited accountability and limited commitment. In developed countries, this separation is likely to be ingrained in the system of government already. However, in developing countries, this needs to be an explicit consideration for reformers. One way this separation can come about is through the creation of an ­independent regulator but, contrary to common wisdom among casual analysts, there are also other approaches that can be more effective under some circumstances. The limited fiscal efficiency in LDCs implies that redistribution needs to be an explicit consideration of regulatory policy, unlike in developed countries. This does not mean that prices should be universally low but, instead, that there is a need for ­carefully designed subsidies and a consideration of how each policy impacts upon poverty and support for reform. Finally,

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Estache and Wren-Lewis: Toward a Theory of Regulation for Developing Countries 765 effective competition, where possible, may mitigate the effects of several institutional limitations. The analysis has also highlighted some areas where the framework of Laffont is somewhat insufficient and here there is a need for further research. In particular, limited regulatory capacity makes it essential to recognize the incompleteness of the regulatory contract. Furthermore, the reduced accountability and commitment powers of governments in LDCs imply that theory must understand better the way multiple principals interact in forming regulatory policy. Incorporating these elements into a theoretical framework will help to analyze the interaction of institutional weaknesses, which needs to be studied further. An aim of future research should be to build a dynamic model that explores the way in which the optimal policy set will change over time as institutions within a country develop. Overall, the strongest conclusion is that institutional weaknesses in developing countries will make the optimal regulatory policy different from that of developed countries. Many of the policies proposed by the theory we have reviewed are divergent from those that are currently seen as “best practice” within OECD countries. Moreover, since the strength of institutions varies considerably between developing countries, there will not be a complete policy set of “best practice” in LDCs. It is, thus, insufficient and possibly damaging to advocate simply for a regulatory framework that is close to some universal ideal. An understanding of the institutional context and its implications are crucial when designing a regulatory framework for developing countries. References Acemoglu, Daron. 2003. “Why Not a Political Coase Theorem? Social Conflict, Commitment, and ­Politics.” Journal of Comparative Economics, 31(4): 620–52.

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Acemoglu, Daron, Simon Johnson, and James A. Robinson. 2005. “Institutions as a Fundamental Cause of Long-Run Growth.” In Handbook of Economic Growth, Volume 1A, ed. Philippe Aghion and Steven N. Durlauf, 385–472. Amsterdam and San Diego: Elsevier, North-Holland. Acemoglu, Daron, and James A. Robinson. 2008. “Persistence of Power, Elites, and Institutions.” American Economic Review, 98(1): 267–93. Ades, Alberto, and Rafael Di Tella. 1999. “Rents, Competition, and Corruption.” American Economic Review, 89(4): 982–93. African Forum for Utility Regulation. 2002. “Regulatory Governance.” http://www1.worldbank.org/afur/ docs/Regulatory%20Governance_Draft2.doc. Aghion, Philippe, Mathias Dewatripont, and Patrick Rey. 1994. “Renegotiation Design with Unverifiable Information.” Econometrica, 62(2): 257–82. Ahrend, Rudiger, and Carlos Winograd. 2006. “The Political Economy of Mass Privatisation and Imperfect Taxation: Winners and Losers.” Public Choice, 126(1–2): 201–24. Alcazar, Lorena, Manuel A. Abdala, and Mary M. Shirley. 2002. “The Buenos Aires Water Concession.” In Thirsting for Efficiency: The Economics and Politics of Urban Water System Reform, ed. Mary M. Shirley, 65–102. Amsterdam; London and New York: Elsevier Science, Pergamon. Andres, Luis, J. Luis Guasch, Thomas Haven, and Vivien Foster. 2008. The Impact of Private Sector Participation in Infrastructure: Lights and Shadows, and the Road Ahead. Washington, D.C.: World Bank. Andres, Luis, J. Luis Guasch, and Stephane Straub. 2007. “Do Regulation and Institutional Design Matter for Infrastructure Sector Performance?” World Bank Policy Research Working Paper 4378. Anton, James J., James H. Vander Weide, and Nikolaos Vettas. 2002. “Entry Auctions and Strategic Behavior under Cross-Market Price Constraints.” International Journal of Industrial Organization, 20(5): 611–29. Armstrong, Mark, Simon Cowan, and John Vickers. 1994. Regulatory Reform: Economic Analysis and British Experience. Cambridge and London: MIT Press. Armstrong, Mark, Chris Doyle, and John Vickers. 1996. “The Access Pricing Problem: A Synthesis.” Journal of Industrial Economics, 44(2): 131–50. Armstrong, Mark, and David E. M. Sappington. 2006. “Regulation, Competition, and Liberalization.” Journal of Economic Literature, 44(2): 325–66. Armstrong, Mark, and David E. M. Sappington. 2007. “Recent Developments in the Theory of Regulation.” In Handbook of Industrial Organization, Volume 3, ed. Mark Armstrong and Robert H. Porter, 1557–1700. Amsterdam: Elsevier, North-Holland. Armstrong, Mark, and John Vickers. 1993. “Price Discrimination, Competition and Regulation.” Journal of Industrial Economics, 41(4): 335–59. Auriol, Emmanuelle, and Pierre M. Picard. 2009.

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